See attached

Week 2 – Assignment: Interpret the Significance of the

Balance of Payments

After completing external research, write a paper to summarize, analyze, and interpret the significance of the Balance of Payments (BOP). Please organize your paper as follows:

1. Define the BOP, and discuss the general accounting that goes into the development of the statement.

2. Access the Current Account for the US from the International Monetary Fund web site, and report these figures in both tables, and graphic format for the years 2007 to present.  Explain the nature of the metrics that are presented. Access the Financial Account for the US from the International Monetary Fund web site, and report these figures in both tablular and graphic format for the years 2007 to present. Explain the nature of the metrics presented.

3. Using the data that you constructed in Part 2 above, describe the meaning that you would take from these metrics and trends for a multinational business manager. Further, discuss how the BOP data is related to exchange rates. Discuss the meaning of the J-curve and what that can mean for the business manager at a Multinational firm.

Support your paper with at least five (5) resources. In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included. Your paper should demonstrate thoughtful consideration of the ideas and concepts that are presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.

Length: 5-7 pages (not including title and reference pages).

Balance of Payments

The measurement of international economic transactions between the locals and the foreigners is called the balance of payments (BOP). Business managers as well as government policy officials should be familiar with and be guided by the BOP data. There are two important accounts that make up the BOP: the Current Account and the Financial Account. Moreover, the BOP metrics are related to exchange rate movements, and this week’s activity is designed to understand that important relationship. This week you will have an opportunity to summarize, analyze, and interpret the significance of BOP.

J. Account. Public Policy 32 (2013) 1–25

Contents lists available at SciVerse ScienceDirect

J. Account. Public Policy

j o u r n a l h o m e p a g e : w w w . e l s e v i e r . c o m / l o c a t e / j a c c p u b p o l

Analyst coverage

, earnings management and financial
development: An international study

François Degeorge a, Yuan Ding b,⇑, Thomas Jeanjean c, Hervé Stolowy d
a Swiss Finance Institute, University of Lugano, Switzerland
b China Europe International Business School (CEIBS), Shanghai, China
c ESSEC Business School, France
d HEC Paris, France

a b s t r a c t

0278-4254/$ – see front matter � 2012 Elsevier In
http://dx.doi.org/10.1016/j.jaccpubpol.2012. 10.003

⇑ Corresponding author. Address: Department
(CEIBS), 699, Hongfeng Road, Pudong, Shanghai 20

E-mail addresses: francois.degeorge@lu.unisi.ch
stolowy@hec.fr (H. Stolowy).

Using data from 21 countries, this paper analyzes the relation
among analyst coverage, earnings management and financial
development in an international context. We document that the
effectiveness of financial analysts as monitors increases with a
country’s financial development (FD). We find that in high-FD
countries, increased within-firm analyst coverage results in less
earnings management. Such is not the case in low-FD countries.
Our results are economically significant and robust to reverse cau-
sality checks. Our findings illustrate one mechanism through
which financial development mitigates the cost of monitoring
firms and curbs earnings management.

� 2012 Elsevier Inc. All rights reserved.

1. Introduction

A large body of research explores the differences between financial systems worldwide and docu-
ments the positive effects of financial development: It boosts industry growth, the formation of new
establishments, and capital allocation (Beck and Levine, 2002). It predicts capital accumulation and
productivity improvements (Levine and Zervos, 1998). It is especially important for firms that depend
on external financing (Demirgüç-Kunt and Maksimovic, 1998; Rajan and Zingales, 1998).

While the benefits of financial development appear to be well established, the detailed mecha-
nisms through which these benefits are brought to bear are still largely unknown. Levine (1997) lists

c. All rights reserved.

of Finance and Accounting, China Europe International Business School
1206, China. Tel.: +86 21 2890 5606; fax: +86 21 2890 5620.
(F. Degeorge), dyuan@ceibs.edu (Y. Ding), jeanjean@essec.edu (T. Jeanjean),

http://dx.doi.org/10.1016/j.jaccpubpol.2012. 10.003

mailto:francois.degeorge@lu.unisi.ch

mailto:dyuan@ceibs.edu

mailto:jeanjean@essec.edu

mailto:stolowy@hec.fr

http://dx.doi.org/10.1016/j.jaccpubpol.2012. 10.003

http://www.sciencedirect.com/science/journal/02784254

http://www.elsevier.com/locate/jaccpubpol

2 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

five basic functions of a financial system: (1) to facilitate risk sharing; (2) to allocate resources; (3) to
monitor managers; (4) to mobilize savings; and (5) to facilitate the exchange of goods and services.

Our paper’s contribution is to focus on the monitoring function; specifically, on financial analysts as
monitors of firms. We find that higher financial development is associated with a greater effectiveness
of monitoring by financial analysts. Using a sample of 21 countries from 1994 to 2002, we find that in
countries with highly developed financial systems (hereafter ‘‘high-FD countries’’), increased within-
firm coverage results in less earnings management. Such is not the case in countries with less well-
developed financial systems (hereafter ‘‘low-FD countries’’).

There is evidence, both systematic and anecdotal, that financial analysts perform an important
monitoring role, at least in the United States. Dyck et al. (2010) document that, in the US, financial
analysts are among the quickest detectors of fraud. For example, in the mid-1990s Sunbeam, an appli-
ance manufacturer, engaged in ‘‘bill-and-hold’’ deals with retailers: The retailers bought Sunbeam
products at large discounts, but the products were then stored by the manufacturer at third-party
warehouses for later delivery. In effect, Sunbeam was shifting revenue from the future to the present.
The first warning to shareholders that Sunbeam was engaging in extensive earnings management
came from a PaineWebber analyst, who noticed unusually large increases in sales of Sunbeam electric
blankets in the summer and outdoor barbecue grills around Christmas time (Byrne, 1998).

The Sunbeam example illustrates a broader pattern. Using US data, Yu (2008) finds that earnings
management tends to be lower in companies followed by more financial analysts. It is not hard to
see why this might be so. Analysts have plenty of opportunities to probe a company’s accounts to
see whether they paint a fair picture of the company’s true health. Provided they perform their duties
with a modicum of diligence, the very fact that they are watching can in itself be a deterrent to earn-
ings management and other activities that might embarrass corporate management. All else being
equal, a company followed by financial analysts has less leeway to manipulate its earnings.

Findings based on US data, however, do not necessarily apply to countries with lower levels of
financial development. To monitor company managers, analysts must overcome severe hidden infor-
mation and hidden action problems: Managers might hide negative information about the company’s
prospects; they might hide some of their actions if they fear retribution from investors; they might be
unable to reveal positive information about the firm to investors. We expect these difficulties to be
easier to overcome in more financially developed countries like the United States. Holding constant
incentives to manage earnings, we discuss possible reasons for this difference: Greater transparency
may facilitate analyst monitoring in high-FD countries; investor demand for analyst monitoring
may be greater; firms’ incentives to facilitate analyst monitoring may be larger; and the quality and
depth of the financial analyst pool may be improved.

We measure the effectiveness of analyst coverage of managers by the impact of that coverage on
earnings management by companies. We posit that if more analyst coverage results in less earnings
management, then analysts are useful monitors of managers’ actions; this leads to our first testable
hypothesis. If a country’s level of financial development enhances analyst monitoring, then the asso-
ciation between analyst coverage and earnings management should be more negative in more finan-
cially developed countries.

Not everyone shares the view that the presence of financial analysts reduces earnings manage-
ment. On the contrary, financial analysts in the United States have been accused of encouraging earn-
ings management by setting company managers targets that are impossible to meet – except by
manipulating company performance (Levitt, 1998; Fuller and Jensen, 2002). If the weight of analyst
opinion is greater in more financially developed countries, the analyst’s target-setting role, and the
associated pressure on companies to meet those targets, may also be greater (Brown and Higgins,
2001, 2005). According to this view, as one moves from low-FD to high-FD countries, companies
would become more fixated on trying to meet or beat the analyst consensus benchmark; this reason-
ing produces our second testable hypothesis: Analyst coverage leads to more earnings management in
more financially developed countries.

Using a sample of 21 countries from 1994 to 2002 and controlling both for firm incentives to man-
age earnings (through various firm characteristics like size, leverage and growth) and for earnings
management variation among countries and industries (through firm fixed effects), we find support
for our first hypothesis: Financial development is associated with more effective monitoring

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 3

effectiveness by analysts. In high-FD countries, increased within-firm analyst coverage is associated
with less earnings management: as analyst coverage moves from zero to one analyst (and respectively
from zero to two analysts) earnings management falls by about 5% (respectively, 8%). By contrast, in
low-FD countries analyst coverage is not associated with a reduction in earnings management. Our
results are robust to corrections for reverse causality. We find no support for our second hypothesis.

Our paper is at the intersection of two streams of literature. The first one considers the influence of
analysts on earnings management. Degeorge et al. (1999) and Burgstahler and Eames (2006) show
that in the US managers tend to manipulate earnings in order to reach the analysts’ consensus. Both
studies are limited to a sample of firms actually covered by analysts, and they only consider the role of
analysts when firms are near the consensus. Yu (2008) extends the scope of these studies by analyzing
US firms both covered and not covered by analysts. He finds that firms with high analyst coverage
have a lower level of discretionary accruals than firms with low coverage. His findings, however, can-
not automatically be applied to other countries. We contribute to this field of literature by showing
that analyst coverage reduces earnings management only in highly financially developed countries.

Our paper also contributes to the literature that analyzes the country-level determinants of earn-
ings management. Past literature shows that earnings management decreases with investor protec-
tion (Leuz et al., 2003; Haw et al., 2004) and that financial development is positively correlated
with investor protection (see Beck et al., 2003; Beck and Levine, 2005). We find that private monitor-
ing activity (analyst following) complements country-level institutional characteristics. In other
words, previous country-level work may actually have underestimated the costs of poor institutions
(i.e., weak investor protection) by failing to take into account this complementarity between firm-
level and country-level mechanisms.

The remainder of this paper is organized as follows: Section 2 develops our research hypotheses.
Section 3 discusses our research design. Section 4 presents our main empirical findings. Section 5 takes
a deeper look at the link between analyst coverage and financial development and Section 6 concludes.

2. Hypothesis development

In their seminal article, Jensen and Meckling (1976) hint at the role of financial analysts in promot-
ing good corporate governance:

We would expect monitoring activities to become specialized to those institutions and individuals
who possess comparative advantages in these activities. One of the groups who seem to play a large
role in these activities is composed of the security analysts employed by institutional investors, bro-
kers, and investment advisory services [. . .] To the extent that security analysts’ activities reduce the
agency costs associated with the separation of ownership and control they are indeed socially produc-
tive. (Jensen and Meckling, 1976, p. 354).

Analysts have the means to be monitors. Unlike most investors, they are trained to analyze the
numbers produced by companies and they enjoy privileged access to company management. Analysts
also have a motive to be monitors. They could look foolish and see their reputations suffer if their re-
search reports and recommendations were based on manipulated numbers. Anecdotal evidence, such
as the Sunbeam example given above, suggests that financial analysts do sometimes perform an
important monitoring role. Dyck et al. (2010) document that in the United States analysts are among
the quickest monitors of fraud. Yu (2008) finds that US firms followed by more analysts manage their
earnings less.

Our goal is to assess empirically whether analyst coverage also functions as a curb on earnings
management in countries that are less financially developed than the United States. Beck and Levine
(2002) define financial development as ‘‘the degree to which national financial systems assess firms,
monitor managers, facilitate risk management, and mobilize savings’’ (p. 160).1 Analysts are more
likely to be effective monitors in curbing earnings management in high-FD countries than in low-FD
countries for at least four reasons: in high-FD countries:

1 Note that financial development is a concept distinct from legal origin, investor protection or legal enforcement, see Section
3.2, Sample and data.

4 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

– The supply of information is likely to be better.
– The demand for information by investors is likely higher.
– Followed firms have higher incentives to be monitored.
– Financial analysts are likely to be of higher quality.

First, financial analysts may be better able to perform their monitoring role when information is
more diffuse. Dyck et al. (2010), for instance, discuss the importance of Hayek’s ‘‘diffuse information’’
concept in the context of fraud detection. Consider two possible stylized environments in which an
analyst might operate. In one environment, which we associate with high-FD countries, analysts have
several sources of information at their disposal to use to check the plausibility of statements made by
the companies they follow. This diffuseness of information is partly due to stricter and better-enforced
disclosure requirements and partly to the existence of an active and competitive financial community
of investors, journalists, and information sources. An analyst following firm A can obtain data on A’s
activities, projections, strategies, and financial policies, and can then compare that information with
information about companies B and C, comparable firms in the same industry, in effect benchmarking
A’s actions and performance.

In the other environment, which we associate with low-FD countries, disclosure requirements are
minimal and are not enforced. An analyst following firm X has to rely on voluntary and unverifiable
disclosures by X to make an assessment of the firm’s quality and prospects. It is hard to compare com-
pany X with companies Y and Z, for information about all three companies is patchy and unreliable.2

Hope (2003a) finds that across countries, the level of disclosure about accounting policies is inversely
related to forecast errors and dispersion. This finding suggests that the work of analysts is facilitated
in high-disclosure environments typical of high-FD countries.3

Second, the incentives for investors to monitor firms may be greater in high-FD countries. La Porta
et al. (2002) find that firms in countries with more investor protection enjoy stronger market valua-
tions. Investors may have more to lose from misjudging the health of a company in such countries.
Accordingly, investor demand for sophisticated analysis and information is likely to be greater in
high-FD countries, and brokers may dedicate more resources to meet this demand. This suggests that
‘‘coverage’’ does not have the same meaning in different countries with different levels of financial
development: Coverage initiation by an analyst is a significant event for a company operating in a
high-FD country. It is not so for a low-FD country, where analyst time may be too thinly spread.4

Third, firms have a greater incentive to be properly monitored by analysts in high-FD countries.
Firms in high-FD countries enjoy greater access to outside capital than firms in low-FD countries, at
least potentially; that is, provided they succeed in convincing outside investors to purchase their secu-
rities. We would then expect firms in high-FD countries to do more to facilitate the work of the finan-
cial analysts monitoring them – by organizing company visits, being responsive to analysts’ requests
for clarifications, and giving analysts access to top management – since these firms stand to lose sub-
stantially due to analyst distrust. By contrast, firms in low-FD countries have little to gain from favor-
able analyst opinion, since access to outside finance is limited anyway.

Finally, the pool of financial analysts may be of better quality in high-FD countries. Financial ana-
lysts there may be better paid and better trained. This could explain why some financial analysts enjoy
star status in the United States, while no such phenomenon exists in continental Europe. As a first pass
on this issue, we gathered the number of CFA-certified analysts in each of our sample countries, using
the online database at www.cfa.institute.com. We scaled it by the number of listed companies in each
country. The correlation between this ratio and our measure of financial development is positive and

2 These arguments do not assume, even implicitly, that firms are covered exclusively by local analysts, i.e., analysts located in
the same country as the firm. Bae et al. (2008) provide data suggesting the opposite.

3 For a related study suggesting that the quality of analysts’ work is superior in countries with high-quality financial reporting
environments, see Barniv et al. (2005).

4 In his account of his career as a financial analyst in the US, Reingold (in Reingold and Reingold, 2006) states that he took
9 months to write his first report when he started working as a financial analyst at Morgan Stanley. By contrast, in a similar book
about his experience as an analyst in France, Tétreau estimates that a typical French analyst can devote less than 40 h a year of
actual research time to each of the companies he covers (Tétreau, 2005). France is in the middle range of our measure of financial
development.

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 5

statistically significant at the 5% level. If we assume that CFA certification is a proxy for financial ana-
lyst quality, this result suggests that average analyst quality tends to be better in high-FD countries.

All of these arguments suggest that analyst coverage may be more effective in high-FD countries
and lead to our first testable hypothesis:

Hypothesis 1. If a country’s level of financial development enhances analyst monitoring, then the
association of analyst coverage on earnings management should be more negative in more financially
developed countries. We call this the FD enhancement hypothesis.

But the role of financial analysts as corporate monitors has been questioned lately, especially in the
United States – hardly an example of low financial development. Financial analysts have been accused
of fostering earnings management by effectively setting company managers targets that are impossi-
ble to meet – except by manipulating company performance (see Levitt, 1998; Collingwood, 2001;
Fuller and Jensen, 2002). In Michael Jensen’s words:

‘‘Indeed, ‘‘earnings management’’ has been considered an integral part of every top manager’s job
for at least the last two decades. But when managers smooth earnings to meet market projections,
they are not creating value for the firm; they are both lying and making poor decisions that destroy
value’’ (Jensen, 2005, p. 8).

Systematic evidence supports these claims. Using US data, Degeorge et al. (1999) document sharp
discontinuities in the forecast error distribution at zero, suggesting that firms strive to meet or exceed
analysts’ consensus forecasts for quarterly earnings. Graham et al. (2005) find that top US executives
admit that they pass up positive NPV projects to meet earnings benchmarks. This suggests that in a
financially developed country such as the US, analyst coverage might actually increase earnings
management.5

We would expect the same four factors that enhance the quality of analyst coverage in high-FD
countries (better supply of information, greater demand for information, higher incentives to be mon-
itored, higher quality of financial analysts) to give greater weight to analyst opinion in those countries.

High-FD

countries might then be associated with a greater role for analysts in setting targets, and
companies there might engage in more earnings management to reach the consensus forecast than
they do in low-FD countries.

According to this view, as one moves from low-FD to high-FD countries, companies would become
more fixated on trying to meet or beat the analyst forecast; this produces our second testable
hypothesis:

Hypothesis 2. The association between analyst coverage and earnings management is more positive
in high financially developed countries than in low financially developed countries. We call this the FD
analyst consensus fixation hypothesis.

Thus, the effect of financial development on the quality of analyst coverage is a priori ambiguous.
The relation of earnings management and analyst coverage is jointly determined by the four factors:
managerial incentives of earnings management, managerial ability of earnings management, incen-
tives of high-quality monitoring by analysts and the ability of high-quality monitoring by analysts.6

In our previous hypothesis development, while a higher level of financial development may enhance
analysts’ ability to perform their monitoring tasks, the increased company fixation on meeting the ana-
lysts’ forecast targets in high-FD countries might create earnings management incentives that would not
exist in low-FD countries. Ultimately, the question of whether financial development tends to facilitate
the analysts’ monitoring role or whether it encourages a dysfunctional game of manipulation to meet
analysts’ earnings targets is an empirical issue.

5 Jumps in the earnings forecast error distribution could be due both to earnings management and to forecast management
(Brown and Higgins, 2001, 2005), that is, managers attempting to downplay analysts’ earnings expectations to make them easier to
beat. Several US-based studies report findings consistent with both interpretations. Hirst et al. (2008) provide a framework in
which to view management earnings forecasts.

6 We thank an anonymous reviewer for bringing up this point.

6 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

3. Research design

3.1. Methodology

We use the following regression to assess the impact of financial development on the enhancement
of analyst monitoring for firm i in country j in year t:

7 Hop
studies
institut
this iss
valuatio

EM Activityijt ¼ a0 þ a1Analyst Coverageijt þ a2Analyst Coverageijt � Medium FDj
þ a3 Analyst Coverageijt � High FDj þ a4 Control variablesijt þ eijt ð1Þ

The dependent variable, EM Activity, is the amount of earnings management by a company in a
year. Medium FD (resp. High FD) is a dummy variable equal to one if the company is in a medium-
FD country (resp. high-FD country), and zero otherwise. We explain the details of the construction
of our variables below and provide the exact definitions of all variables in Appendix A.

To test the FD enhancement hypothesis, the coefficients of interest to us are a1, a2, and a3. If finan-
cial development is associated with analyst coverage, then a given amount of incremental analyst cov-
erage should result in a greater reduction in earnings management as we move up in the level of
financial development. a1 measures the effect of analyst coverage on earnings management in low-
FD countries. a1 + a2 measures the impact of analyst coverage on earnings management in med-
ium-FD countries, while a1 + a3 measures it in high-FD countries. As we have discussed, two opposite
effects may be at work for a2 and a3:

– According to the FD enhancement hypothesis (Hypothesis 1), higher financial development may
facilitate the analysts’ monitoring role, so that we should have a1 + a3 < a1 + a2 < a1 and a1 + a3 should be negative, i.e., analyst coverage reduces earnings management in high-FD countries. We form no expectations about the sign of a1 + a2 and a1.

– According to the FD analyst consensus fixation hypothesis (Hypothesis 2), higher financial develop-
ment may result in companies being more pushed to manage earnings to meet consensus expec-
tations, so that we should have a1 + a3 > a1 + a2 > a1 and a1 + a3 should be positive under analyst
consensus fixation hypothesis, i.e., analyst coverage increases earnings management in high-FD
countries. We form no expectations about the sign of a1 + a2 and a1 under Hypothesis 2.

This formulation clarifies our contribution relative to Yu (2008) who only uses US data. Yu’s mon-
itoring effect hypothesis, for which he finds empirical support, predicts that a1 + a3 < 0. His pressure effect hypothesis, which is rejected by the data, predicts that a1 + a3 > 0. We focus on assessing
whether financial development is associated with the effectiveness of analyst monitoring across
countries.

Several factors might simultaneously influence analyst coverage and earnings management, poten-
tially creating an omitted variable bias. For example, the quality of a firm’s accounting policy might
impact the decision by analysts to follow it and also determine the leeway that managers have in
reporting income. Similarly, the ownership structure of the firm might affect analyst coverage (firms
with small float and trading volume might offer little inducement to analysts to follow them), as well
as the potential and incentives for earnings management. Firms with better corporate governance
might manage their earnings less and at the same time attract more coverage by analysts.7

To take into account this possible bias, we need to control for heterogeneity across observations.
We, therefore, estimate our model using a panel fixed-effects regression, using the firm as the panel
unit. This estimation technique reduces the bias generated by a simple pooled OLS estimation (see
Wooldridge, 2002, p. 421).

e (2003b) finds evidence consistent with disclosures being more important when analyst following is low. While these
do not directly address the link between firm governance characteristics and analyst coverage, it is plausible that larger US
ional stockholdings would encourage financial analysts to follow a company. Lang et al. (2004) provide indirect evidence on
ue. They analyze the relationship between the quality of corporate governance, the extent of analyst coverage, and
n. They find that analysts are less likely to follow firms with potential incentives to manipulate information.

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 7

We use the firm fixed effect to control for all time constant factors at the firm level that may influ-
ence earnings management. In other words, this term accounts for country, industry and firm effects
(see Wooldridge, 2002, p. 441; Dal Bó and Rossi, 2007; Blalock and Simon, 2009, p. 1100).

The GAAP is a time constant factor and we control for it by including a firm fixed effect. Doing so,
we are in particular assuming that all factors (firm-level governance characteristics, GAAP, institu-
tions. . .) that simultaneously influence analyst coverage and earnings management are fixed over
our 1994–2002 sample period. While surely not strictly correct, this assumption is a rough but reason-
able approximation. If it holds, fixed-effect panel estimation will produce consistent estimates.8

Reverse causality is another potential concern in our setting. For example, analysts may shun firms
that they believe have recently started to engage in earnings management. Our fixed-effect procedure
would not correct for this problem. At least two techniques may mitigate this concern: (1) using the
1-year-lagged value of analyst coverage as an instrument for analyst coverage (see Chang et al., 2006);
(2) estimating a two-stage least squares regression (Wooldridge, 2002, p. 461). The lagged value of
analyst coverage is plausibly uncorrelated with the error term in our regression, since analysts made
their coverage decisions before they learned about the firm’s accounting practices or its incentives to
manage its earnings for the current year.

In order to implement a 2SLS regression, we would first need to identify valid instruments, i.e.,
instruments that are uncorrelated with the error term in Eq. (1) but highly correlated with analyst
coverage (Wooldridge, 2002, p. 470). Since using weak instruments may result in biased estimates
(Larcker and Rusticus, 2010), we prefer not to implement a 2SLS regression, given the difficulty of
identifying valid instruments.

We provide definitions of all variables in Appendix A.

3.2. Sample and data

Our initial sample includes listed firms from 42 countries, a subset of that used in La Porta et al.
(1997). Seven countries out of the 49 in their sample are not covered in our primary database sources.
We obtain financial accounting information from the Global (Standard and Poor’s) database, and infor-
mation on analyst coverage from the I/B/E/S database. We use Global data from 1993 to 2002.

Healy and Wahlen (1999) define earnings management as the alteration of firms’ reported eco-
nomic performance by insiders, either to mislead stakeholders or to influence contractual outcome,
for instance to avoid the violation of debt covenants or political costs (Watts and Zimmerman,
1986). To measure earnings management we use short-term (also called working capital or current)
discretionary (also called abnormal) accruals. Discretionary accruals attempt to isolate the ‘‘suspi-
cious’’ part of accruals from that which may be attributed to legitimate business purposes. This is a
standard measure in the accounting and finance literature (e.g., Rangan, 1998; Teoh et al., 1998b,
1998a; DeFond and Park, 2001; Alcarria Jaime and De Albornoz Noguer, 2004; DuCharme et al.,
2004; Park and Park, 2004; Carey and Simnett, 2006; Jo and Kim, 2007; Jaggi et al., 2009;
Rodríguez-Pérez and van Hemmen, 2010). Short-term discretionary accruals are often preferred to to-
tal discretionary accruals because of the possible noises in the measurement of discretionary accruals
due to the impacts from property, plant and equipment. Teoh et al. (1998b, p. 64) explain that ‘‘dis-
cretionary current accruals’’ represent the component most subject to managerial manipulation. In
other words, managers have greater discretion over current accruals than over long-term accruals
(Park and Park, 2004, p. 388),

Appendix B explains the calculation of our earnings management variable. Appendix C explains our
sample construction. Our final sample contains 65,799 firm-year observations from 13,098 firms in 21
countries.

Companies may manage their earnings upward or downward, depending on their situation. In most
of our analyses, we do not condition on the individual companies’ economic situations, and we have
no prior views on the direction of earnings management. Accordingly, we use the absolute value of

8 As a robustness check, we reran our regressions for three sub-periods (1994–1996; 1997–1999; 2000–2002). Assuming that
corporate governance characteristics remain stable over a three-year period seems more reasonable than over a nine-year period.
Results are unchanged (see Table 3).

8 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

short-term discretionary accruals as our measure of earnings management activity, and we label it EM
Activity. Hribar and Nichols (2007) provide evidence on the correlation between unsigned measures of
discretionary accruals and stable firm characteristics such as market value of equity, total assets, sales
growth, leverage, book-to-market ratios, cash from operations, volatility of sales, volatility of earnings,
and volatility of cash flows. This implies that studies using unsigned measures of earnings manage-
ment can suffer from an omitted variable problem if these measures of stable firm characteristics
are not controlled for. Our use of fixed effects in our regressions enables us to steer clear of this prob-
lem because firm fixed effects account for all time constant factors.

Previous work has documented differences in financial system development across countries and
their impact on economic activity.9 We rely on

Beck and Levine (2002)

for our measure of financial
development.10 They compute an overall measure of financial development labeled Finance-Aggregate
as the first principal component of two underlying measures of financial development. The first under-
lying measure (Finance-Activity) is a measure of ‘‘the overall activity of the financial intermediaries and
markets’’ (p. 160). It equals the log of the product of Private Credit (the value of credits by financial inter-
mediaries to the private sector divided by GDP) and Value Traded (the value of total shares traded on the
stock market exchange divided by GDP). The second underlying measure of financial development
(Finance-Size) is a measure of ‘‘the overall size of the financial sector’’ (p. 161) and equals the log of
the sum of Private Credit and Market Capitalization. In the computation of the index, Beck and Levine
aggregate the data over 1980–1989. We divide the 21 countries in our sample into three levels of
financial development (Low FD, Medium FD, and High FD), using a k-means partition cluster analysis.11

We obtained the three following clusters: low financial system development (Austria, Belgium, Denmark,
Finland, India, and Italy), medium financial system development (Australia, Canada, France, Germany,
Great Britain, Malaysia, Norway, South Africa, South Korea, Spain, and Sweden), and high financial
system development (Japan, Netherlands, Singapore, and USA).

The ranking and clustering of countries using the Finance-Aggregate generally corresponds to our
intuition, with a few surprises. For example, Great Britain falls into the medium FD cluster, while Lon-
don is the leading European financial market sector. Note that the Finance-Aggregate measure scores
the size of the financial system relative to GDP. Moreover, Finance-Aggregate incorporates not just
financial market measures, but also bank financing measures. This measure captures both the activity
and the size of the financial sector: this is why Italy ranks low (as the size of its financial sector is lim-
ited compared to other countries) whereas the Netherlands ranks high. Note that our classification of
countries based on financial development is distinct from that based on legal origin (see Table 1).12 For
instance, while both the UK and Germany belong to the medium-FD group, the UK is common-law coun-
try with high investor protection, while Germany is a code-law country with lower investor protection
(see Leuz et al., 2003). In our sample there is no discernible association between finance aggregate and
legal origin (Chi2 = 1.66, p-value = 0.436), neither with investor protection (Chi2 = 7.98, p-value = 0.630),
nor legal enforcement (Chi2 = 18.7, p-value = 0.661).

For each firm-year we collect the number of analysts covering the firm at the time of the last con-
sensus computation before the announcement of the year’s earnings. We use ln(1 + coverage) as our
main independent variable, as we expect the marginal effect of coverage to decrease as coverage
increases.

9 Levine (1997), Demirgüç-Kunt and Maksimovic (1998), Levine and Zervos (1998), Rajan and Zingales (1998), Beck and Levine
(2002), and references therein.

10 This measure has been used in a large number of studies (e.g., Purda, 2008). Cull et al. (2005) use two measures which are
similar in spirit to Beck and Levine (2002)’s one: ‘‘PRIV’’ is the ratio of bank credit to the private sector to GDP and ‘‘LLIAB’’ is the
ratio of liquid liabilities to GDP.

11 k-Means partition cluster analysis breaks the observations into non-overlapping groups. Each observation is assigned to the
group with the closest mean. Based on the new assignment of observations, the algorithm computes new group means, and the
process is iterated until no observations change groups. We decided to split the countries into three groups, which appears to be an
optimal figure (there is enough discrepancy between groups, while keeping a certain degree of simplicity in the treatments). We
ran the treatment with our measure of financial development (the variable Finance-Aggregate), asking for three different
clusterings and, as is the rule, we chose the cluster definition with the highest Calinski–Harabasz pseudo-F. As a robustness check,
we ran all our regressions with a very basic cluster definition, dividing the 21 countries into three groups of equal size by rank of
financial system development. We found qualitatively similar results.

12 For a discussion of problems associated with basing international comparisons on legal origin, see Haxhi and Ees (2010).

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 9

4. Empirical findings

4.1. Univariate findings

Table 1 presents univariate evidence consistent with the FD enhancement hypothesis (Hypothesis
1). In high-FD countries, EM Activity is lower on average for firms followed by financial analysts (4.0%)
than for firms that are not followed (4.3%). The difference, 0.3% of total assets, is statistically significant
at the 1% level and represents about 7% of the average EM Activity for those countries (0.3/4.1). The
picture is similar in medium-FD countries. In low-FD countries, there is no significant difference in
EM Activity between followed and non-followed firms.

Another way to gauge the effect of analyst coverage on earnings management is to compare it to
the effect of financial development. For firms not followed by financial analysts, EM Activity is about
5.2% of lagged total assets in low-FD countries, versus 4.3% in high-FD countries, a 0.9% decrease. So
financial development in and of itself appears to be associated with lower levels of earnings manage-
ment.13 But in switching from not being followed to being followed, a firm in a high-FD country gets a
further reduction of EM Activity equal to 0.3% of total assets. Thus, using these admittedly rough first-
pass measures, the existence of analyst coverage affords companies about a third of the benefits of a
hypothetical upgrade from low to high financial development.

4.2. Multivariate findings

Table 2 reports the results of our main regression equation for firm i in country j in year t:

13 Our
(2003),

14 For
implem

15 Haw
operati
income
activitie

EM Activityijt ¼ a0 þ a1 Analyst Coverageijt þ a2 Analyst Coverageijt � Medium FDj
þ a3Analyst Coverageijt � High FDj þ a4Control variablesijt þ eijt ð2Þ

We are mainly interested in a1 + a3, which measures the impact of analyst coverage on earnings
management in high-FD countries, while a1 + a2 measures it in medium-FD countries. For the sake
of clarity, in Table 2 we report directly the sum of the coefficients a1 + a2 and the associated signifi-
cance level under the label ‘‘Analyst coverage in medium-FD countries’’ and the sum of the coefficients
a1 + a3 and the associated significance level under the label ‘‘Analyst coverage in high-FD countries.’’
At the bottom of Table 2, we provide a comparison of the effect of analyst coverage in high-FD coun-
tries (a1 + a3) and in medium-FD countries (a1 + a2), as well as a comparison of the latter and the effect
of analyst coverage in low-FD countries (a1).

The literature on earnings management shows that abnormal accruals tend to be correlated with
Return on Assets (McNichols, 2000). To control for this performance-related bias, we include Return
on Assets (ROA), the absolute value of Return on Assets (|ROA|), and the change in ROA as independent
variables in our regressions.14 We also include size, leverage, country growth, and year fixed effects as in
Haw et al. (2004).15

Table 2, column 1, reports the results of our baseline model. Based on these estimates, in high-FD
countries a within-firm increase in analyst coverage from zero to one is associated with a reduction in
EM Activity of 0.21% of total assets (0.21% = 0.003 � ln(1 + 1)). This reduction in EM Activity is statis-
tically significant at the 1% level. For non-followed firms in those countries, average EM Activity is 4.3%
of total assets (see Table 1), suggesting that the arrival of the first analyst following a firm in a high-FD
country is associated with an average decline in EM Activity of about 5% (0.21/4.3). When analyst cov-
erage jumps from zero to two in a high-FD country, EM Activity falls by 8% (0.003 � ln(1 + 2))/4.3). We

finding that companies in high-FD countries exhibit lower levels of earnings management activity echoes that of Leuz et al.
who use other measures of earnings management.
a more sophisticated methodology, see Kothari et al. (2005). Due to the international nature of our sample, we cannot
ent their approach for it requires a much larger number of observations than are available.

et al. (2004, p. 436) note that ‘‘large firms likely face increased external monitoring, have more stable and predictable
ons and stronger control structures, and hence report smaller abnormal accruals.’’ They include leverage controls ‘‘for both
-increasing behavior (to alleviate the constraints of accounting-based debt contracts) and income-decreasing managerial
s (to facilitate debt renegotiations in the event of financial distress).’’

Table 1
Univariate statistics.

Level of
financial
development

Country Legal
origin

Investor
protection

Legal
enforcement

Number
of firm-
years

Mean analyst
coverage per
firm

Percentage of
firms followed by
analysts (%)

Finance-
aggregate

EM activity

All
firms
(%)

Firms not
followed by
financial analysts
(%)

Firms followed
by financial
analysts (%)

Low Austria Code 2 9.4 165 1.8 53 0.43 5.2 4.7 5.7
Belgium Code 0 9.4 184 4.0 49 �0.15 4.6 4.9 4.4
Denmark Code 2 10 238 2.7 63 0.07 5.2 4.9 5.4
Finland Code 3 10 203 5.9 69 0.25 5.7 4.5 6.2
India Common 5 5.6 984 2.7 38 �0.36 5.4 5.2 5.6
Italy Code 1 7.1 493 5.1 62 0.13 5.1 5.6 4.8

Overall Low FD 2267 3.5 51 0.26 5.3 5.2 5.3

Medium Australia Common 4 9.5 1347 4.6 67 0.92 4.8 4.8 4.8
Canada Common 5 9.8 2723 4.2 61 0.92 4.6 4.5 4.7
Germany Code 1 9.1 2585 5.8 65 0.95 5.8 5.8 5.8
Spain Code 4 7.1 407 7.8 75 0.49 4.5 4.2 4.7
France Code 3 8.7 2580 4.9 65 0.69 5.6 5.7 5.5
Great
Britain

Common 5 9.2 6239 4.8 46 0.96 5.7 6.3 5.1

South Korea Code 2 5.6 311 4.6 80 0.70 4.6 4.6 4.6
Malaysia Common 4 7.7 2328 2.9 33 0.95 5.5 5.7 5.0
Norway Code 4 10 308 4.1 56 0.59 4.4 4.1 4.5
Sweden Code 3 10 642 3.7 66 0.94 4.9 4.4 5.1
South Africa Common 5 6.4 223 5.9 80 1.08 3.9 3.6 4.0

Overall Medium FD 19,693 4.6 55 0.89 5.4 5.6 5.1

High Japan Code 4 9.2 21,849 2.2 62 1.73 3.4 3.6 3.2
Netherlands Code 2 10 474 11.1 85 1.18 6.2 6.1 6.3
Singapore Common 4 8.9 1126 3.9 49 1.51 5.6 5.8 5.5
USA Common 5 9.5 20,390 5.5 72 1.44 4.7 5.0 4.5

Overall High FD 43,839 3.9 67 1.58 4.1 4.3 4.0
All
countries

65,799 4.1 63 1.33 4.5 4.8 4.3

The sample consists of 65,799 firm-year observations for the fiscal years 1994–2002, across 21 countries and 13,098 non-financial firms. We obtained financial information from the Global
(Standard and Poor’s) Database and coverage information from I/B/E/S. Finance-Aggregate (Beck and Levine, 2002) measures the level of financial development in a country. Legal origin is
a dummy variable coded one if the country has a common law tradition and zero otherwise (La Porta et al., 1998). Investor protection is the anti-director rights index created by La Porta
et al. (1998). It is an aggregate measure of minority shareholder rights and ranges from zero to five. Legal enforcement is developed by Leuz et al. (2003) and is measured as the mean score
across three legal variables used in La Porta et al. (1998): (i) the efficiency of the judicial system, (ii) an assessment of rule of law, and (iii) the corruption index. All three variables range
from 0 to 10. EM Activity is measured as a percentage of lagged total assets.
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our sample construction.

1
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5

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 11

find no such pattern for medium-FD countries, where more analyst coverage is not associated with a
reduction in EM Activity. At the bottom of Table 2, we also test the difference of the effect of analyst
coverage in high-FD countries versus medium-FD countries and in medium-FD countries versus low-
FD countries. Consistent with Hypothesis 1, we find that analyst coverage is more associated with a
reduction in earnings management in high-FD countries than in medium-FD countries (coeff = 1.95,
p = 0.026). For low-FD countries, we find that analyst following is associated with more earnings man-
agement activity (coeff = 0.006, p = 0.021, Table 2, column 1). However, this effect of analyst coverage
on earnings management in low-FD countries turns out to become insignificant when taking into ac-
count reverse causality issues (column 2).16

Table 2, column 2 addresses potential reverse causality concerns: Might analysts base their deci-
sion to follow the firm on whether the firm has recently started to manage its earnings? The results
we obtain are slightly stronger than in the baseline specification of column 1, indicating that reverse
causality does not drive our findings. Once again, we find support for Hypothesis 1: as analyst cover-
age is associated with a greater reduction in earnings management in high-FD countries than in med-
ium-FD countries (coeff = �0.004, p = 0.000 versus coeff = �0.001, p = 0.111, the difference is
significant at the 0.023 level – see bottom of Table 2), whereas medium and low-FD countries are
indistinguishable in terms of effect of analyst coverage on earnings management (coeff = �0.001,
p = 0.111 versus 0.000, p = 0.966, the difference is not statistically significant at conventional levels,
p = 0.374 – see bottom of Table 2).

Table 2, columns 3 and 4, replicate the results of columns 1 and 2 using a panel Weighted Least
Squares (WLS) regression. A potential concern with the results presented in columns 1 and 2 is that
there are large variations in the number of firm-year observations across the countries in our sample,
and the effect of financial development on analyst coverage might be driven by, say, US or Japanese
firms. WLS estimation addresses this problem by giving each firm-year observation a weight that is
inversely proportional to the number of firm-years in the sample for the firm’s country. The results
of columns 3 and 4 are qualitatively similar to those of columns 1 to 3, indicating that the effect of
financial development is more than simply a ‘‘US effect’’ or a ‘‘Japan effect.’’

4.3. Robustness checks

To rule out the possibility of a Fair Disclosure act17 effect in our sample (see Srinidhi et al., 2009), we
ran three tests. First, we excluded years 2001 and 2002 from our sample. Second, we excluded US obser-
vations (and US observations and all post 2000 observations in a subsequent test). All specifications lead to
coefficients consistent with those reported in Table 2. Finally, we also rerun equation 2 for three sub-sam-
ples: 1994–1996; 1997–1999 and 2000–2002. The advantage of this test is twofold. First, we control for
changes in the regulatory landscape (such as the Fair Disclosure act) that might impact our findings. If
any regulation adopted during a sub-period has an impact, then we should observe differences in the coef-
ficients on the variables of interest across sub-samples. Second, while firm fixed effects are included in Eq.
(1), our study for the whole nine-year observation period, it is possible that firms experience some changes
during this period. Running equation 2 on short time periods (three periods of 3 years instead of 9 years)
helps to relax this assumption. Table 3 reports our findings, which are consistent with those of Table 2.

We run some additional tests in order to see if our results are driven by one particular country. We
exclude countries one by one and findings (untabulated) are similar to those reported in Table 2.

To better understand the interaction term results in Table 2, we divide the sample into the high and
low-FD subsamples, then rerun the model without the interaction term to evaluate the coefficient of
analyst coverage, One advantage of this specification is that we do not constrain coefficient on control
variables to be identical for low and high-FD countries. Table 4 presents our findings. They are quite
consistent with those of Table 2.

We also run a test to ensure that using firm fixed effects is adequate. Because our sample is large and
varied, firm specific differences in addition to country specific differences may not be fully taken into

16 As is apparent from Table 1, the mean analyst coverage per firm varies across countries. In results not reported, we replicated
all of our analyses by scaling Analyst Coverage by its maximum number in each country. Our results were qualitatively unchanged.

17 The fair disclosure act is limited to US firms or to firms listed in the US.

Table 2
Panel firm fixed-effects regression – Earnings management, analyst coverage, and financial system development.

Panel A: OLS panel firm fixed-effects
regressions

Panel B: WLS panel firm-fixed effects
regressions

Analyst
coverage = ln[1 + #
of analysts]

Analyst
coverage = lag
ln[1 + # of analysts]

Analyst
coverage = ln[1 + #
of analysts]
Analyst
coverage = lag
ln[1 + # of analysts]

(1) (2) (3) (4)
b/t

b/t b/t b/t

a1 Analyst coverage in
low-FD countries

0.006** 0.000 0.007** 0.001

(0.021) (0.966) (0.021) (0.686)
a1 + a2 Analyst coverage in

medium-FD countries
�0.004 �0.001 �0.001 �0.002

(0.962) (0.111) (0.498) (0.164)
a1 + a3 Analyst coverage in

high-FD countries

�0.003*** �0.004*** �0.002*** �0.004***

(0.000) (0.000) (0.001) (0.000)
ROA 0.000 0.000 0.000 0.000

(0.454) (0.605) (0.926) (0.870)
|ROA| 0.000 0.000 0.000 0.000

(0.073) (0.134) (0.774) (0.757)
Change in ROA 0.000* 0.000* 0.000*** 0.000**

(0.062) (0.067) (0.008) (0.015)
Size 0.000 0.000 �0.001* �0.001

(0.536) (0.704) (0.063) (0.162)

Leverage

0.000 0.000 0.000 0.000

(0.255) (0.430) (0.651) (0.725)
Growth 0.064*** 0.061*** 0.075*** 0.071***

(0.000) (0.000) (0.000) (0.000)
Firm fixed effects Included Included Included Included
Year fixed effects Included Included Included Included

Number of observations 65,799 63,113 59,560 59,560
F 28.9 28.7 18.9 20.565
Prob > F 0.000 0.000 0.000 0.000
R-squared 0.405 0.405 0.391 0.392
Adjusted R-squared 0.257 0.258 0.242 0.243

t-Statistic for a one-sided
test that
a1 + a3 < a1 + a2

1.95 1.99 3.21 2.33

p-Value 0.026 0.023 0.001 0.010
t-Statistic for a one-sided

test that a1 + a2 < a1 2.70 0.321 2.78 0.789

p-value 0.003 0.374 0.003 0.215

For firm i in country j in year t: EM Activityijt ¼ a0 þ a1 Analyst Coverageijt þ a2 Analyst Coverageijt � Medium FDj þ a3 Analyst
Coverageijt � High FDj þ a4 Control variablesijt þ eijt .

The dependent variable is EM Activity. Column 1 reports the results of the basic model, in which Analyst Coverage is measured
as ln(1 + number of analysts following the firm). In column 2 we use the one-year lagged value of ln(1 + number of analysts
following the firm) as our instrument for Analyst Coverage. Columns 3 and 4 replicate columns 1 and 2 with a WLS regression.
We sorted countries into three categories of financial development (high FD, medium FD, low FD) based on the Finance-
Aggregate measure of Beck and Levine (2002). Medium FD (respectively High FD) is a dummy variable equal to one if the
company is from a medium-FD country (resp. high-FD country), and zero otherwise. ROA, |ROA|, and DROA are, respectively;
the Return on Assets, the absolute value of ROA, and the change in ROA. Size ranges from 1 to 10, corresponding to the decile (1:
lowest; 10: highest) of total assets for the firm-year. Deciles are computed country by country. Leverage is the ratio of total
debts to total assets. Growth is the mean annual GDP growth rate per country. We report p-values in parentheses below the
coefficients. In the last two lines of the table, we report the absolute value of the t-statistic and the associated p-value for the
test of the difference between a1 + a3 and a1 + a2 (first line), between a1 + a2 and a1 (second line).
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our
sample construction.
* Significant at the 10% level.
** Significant at the 5% level.
*** Significant at the 1% level.

12 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 13

account. To mitigate this concern, we present two additional tables. In Table 5, all continuous variables
are standardized (centered on the country mean and scaled by the standard deviation of the variable).
Taking the difference from the country means helps remove invariant yearly components per country
from the models. Findings are consistent with our main results. A change in one standard deviation in
analyst following translates in no change in earnings management in low-FD (the coefficient is not sig-
nificantly different from zero); while it is associated with lower earnings management by 0.722 standard
deviation in medium-FD countries, by 1.122 standard deviation in high-FD countries.

In Table 6, we include the main effects (

Medium-FD

and High-FD) in addition to interaction terms
along with industry, country and year fixed effects. This specification is costly as we do not control for
time invariant fixed effect at the firm level. However, as we incorporate the main effects, the economic
interpretation of the findings is more straightforward. Findings concerning the main effects are con-
sistent with intuition: earnings management is less pronounced in medium-FD countries (�0.012 in
column 1, �0.009 in column 2) compared to low-FD countries (which is the base group); and less per-
vasive in High-FD countries (�0.015, p = 0.013) than in Medium-FD countries. Interaction terms are
consistent with those reported in Table 2. The coefficient on Analyst Coverage measures the effect of
analyst coverage on earnings management in low-FD countries. This coefficient is positive and signif-
icant in column 1 and insignificant otherwise. The coefficient on the interaction term Analyst Coverage
� Medium-FD countries is insignificant in all columns (�0.004, p = 0.962 in column 1, p = 0.111 in col-
umn 2, p = 0.762 in column 3 and p = 0.225 in column 4), meaning that the effect of analyst coverage
on earnings management in medium-FD countries is not distinguishable from its effect in low-FD
countries. The coefficient on the interaction term Analyst Coverage � High-FD countries is significant
and negative in all specifications (�0.003 in column 1, �0.004 in column 2, �0.002 in column 3
and �0.004 in column 4). In other words, analyst coverage is associated with less earnings manage-
ment in high-FD countries where as it is not the case in low-FD countries.

5. A closer look at the FD analyst consensus fixation hypothesis

Our findings support the FD enhancement hypothesis (Hypothesis 1), and run against the FD ana-
lyst consensus fixation hypothesis (Hypothesis 2). Since the predictions of those hypotheses run in
opposite directions, our results are consistent with two different interpretations. Under the first inter-
pretation, both hypotheses have empirical validity, but the FD consensus fixation effect is more than
offset by the FD enhancement effect. The FD consensus fixation effect might be strong for firms with
earnings near the consensus, but non-existent for firms with unmanaged earnings ‘‘far’’ from the con-
sensus, for which analysts deter earnings management. Since most firms don’t have earnings close to
the consensus, the FD enhancement effect prevails over the FD consensus fixation effect. Under the
second interpretation, the FD analyst consensus fixation hypothesis is simply rejected by the data.
We run additional tests to disentangle between these two interpretations. Our evidence is more con-
sistent with the second interpretation.

Our approach is twofold: First, we examine the premise that companies in high-FD countries are
more fixated on trying to meet or beat the analyst forecast than firms in low-FD countries; we find
little support for this premise. Second, we tilt our analysis in favor of the FD fixation hypothesis by
focusing on a sub-sample of firms in which analyst fixation is likely to be highest. Even then, we find
no support for the FD fixation hypothesis.

5.1. Analyst consensus fixation is not higher in high-FD countries

Recall the logic of the FD analyst consensus fixation hypothesis: The increased fixation on meeting
the analysts’ forecast targets in high-FD countries might create earnings management incentives that
would not exist in low-FD countries. An untested premise of this hypothesis is that analyst consensus
fixation18 is higher in high-FD countries. We now test this premise directly.

18 Graham et al. (2005, p. 5) argue that ‘‘the two most important earnings benchmarks are quarterly earnings for the same
quarter last year and the analyst consensus estimate’’. We use the term ‘‘analyst consensus benchmark’’ to refer to the analyst
consensus estimate taken as a benchmark.

Table 3
Panel firm fixed-effects regression – earnings management, analyst coverage, and financial system development by sub-periods.

1994–1996 1997–1999 2000–2002

Analyst
coverage = ln[1 + # of
analysts]

Analyst
coverage = ln[1 + # of
analysts]
Analyst
coverage = ln[1 + # of
analysts]
b/t b/t b/t

a1 Analyst coverage in low-FD
countries

0.005** 0.007** 0.003*

(0.031) (0.015) (0.051)
a1 + a2 Analyst coverage in

medium-FD countries
�0.014 0.081 �0.003

(0.621) (0.329) (0.234)
a1 + a3 Analyst coverage in high-

FD countries
�0.002** �0.002*** �0.004***

(0.000) (0.000) (0.000)
ROA 0.000 0.000 0.000

(0.512) (0.417) (0.424)
|ROA| 0.000 0.000 0.000

(0.081) (0.096) (0.062)
Change in ROA 0.000* 0.000* 0.000*

(0.062) (0.062) (0.062)
Size 0.000 0.000 0.000

(0.623) (0.469) (0.376)
Leverage 0.000 0.000 0.000

(0.328) (0.721) (0.155)
Growth 0.054*** 0.041*** 0.049***

(0.000) (0.000) (0.000)
Firm fixed effects Included Included Included
Year fixed effects Included Included Included

Number of observations 65,799 65,799 65,799
F 29.200 28.517 28.278
Prob > F 0.000 0.000 0.000
R-square 0.412 0.398 0.399
Adjusted R-square 0.263 0.246 0.246

t-Statistic for a one-sided test that
a1 + a3 < a1 + a2

3.067 2.765 2.852

p-Value 0.001 0.003 0.002
t-Statistic for a one-sided test that

a1 + a2 < a1 1.813 2.701 1.367

p-Value 0.035 0.003 0.086

The dependent variable is EM Activity. Columns 1, 2 and 3 respectively tabulate the findings of our main regression for three
3-year periods in our sample: 1994–1996, 1997–1999 and 2000–2002. Analyst Coverage is measured as ln(1 + number of
analysts following the firm). We sorted countries into three categories of financial development (high FD, medium FD, low FD)
based on the Finance-Aggregate measure of Beck and Levine (2002). Medium FD (respectively High FD) is a dummy variable
equal to one if the company is from a medium-FD country (resp. high-FD country), and zero otherwise. ROA, |ROA|, and DROA
are, respectively; the Return on Assets, the absolute value of ROA, and the change in ROA. Size ranges from 1 to 10, corre-
sponding to the decile (1: lowest; 10: highest) of total assets for the firm-year. Deciles are computed country by country.
Leverage is the ratio of total debts to total assets. Growth is the mean annual GDP growth rate per country. We report p-values
in parentheses below the coefficients. In the last two lines of the table, we report the absolute value of the t statistic and the
associated p value for the test of the difference between a1 + a3 and a1 + a2 (first line), between a1 + a2 and a1 (second line).
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our
sample construction.
* Significant at the 10% level.
** Significant at the 5% level.
*** Significant at the 1% level.

14 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

Table 7 reports the country-by-country ratios of small positive to small negative earnings surprises.
This ratio measures the importance of the analyst consensus as a benchmark: Small positive surprises

Table 4
Panel firm fixed-effects regression – earnings management, analyst coverage, and financial system development – by low-FD –
high-FD sub samples.

Low FD High FD
Analyst coverage = ln[1 + # of analysts] Analyst coverage = ln[1 + # of analysts]
b/t b/t

Analyst coverage 0.005** �0.004**
(0.011) (0.017)

ROA 0.000 0.000
(0.321) (0.502)

|ROA| 0.000 0.000*

(0.082) (0.058)
Change in ROA 0.000* 0.000**

(0.082) (0.031)
Size 0.000 0.000

(0.621) (0.321)
Leverage 0.000 0.000

(0.110) (0.321)
Growth 0.044*** 0.072***

(0.000) (0.000)
Firm fixed effects Included Included
Year fixed effects Included Included

Number of observations 2267 43,839
F 15.2 32.0
Prob > F 0.000 0.000
R-square 0.351 0.421
Adjusted R-square 0.231 0.287

For firm i in country j in year t: EM Activityijt ¼ a0 þ a1 Analyst Coverageijt þ a2 Control variablesijt þ eijt .
The dependent variable is EM Activity. The sample is divided into the high (Column 1) and low-FD (Column 2). The basic model
is run without the interaction term to evaluate the coefficient of analyst coverage, Analyst Coverage is measured as
ln(1 + number of analysts following the firm). We sorted countries into two categories of financial development (high FD, low
FD) based on the Finance-Aggregate measure of Beck and Levine (2002). ROA, |ROA|, and DROA are, respectively; the Return on
Assets, the absolute value of ROA, and the change in ROA. Size ranges from 1 to 10, corresponding to the decile (1: lowest; 10:
highest) of total assets for the firm-year. Deciles are computed country by country. Leverage is the ratio of total debts to total
assets. Growth is the mean annual GDP growth rate per country. We report p-values in parentheses below the coefficients.
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our
sample construction.
* Significant at the 10% level.
** Significant at the 5% level.
*** Significant at the 1% level.

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 15

should outnumber small negative surprises as firms strive to beat the consensus. If the pressure on
firms to do so is greater in high-FD countries, we should observe a higher small positive/small negative
ratio in more financially developed countries.

We use two definitions of ‘‘small’’ earnings surprise. In Table 7, column 2, we define a small earn-
ings surprise as within 0.13% of the stock price. We base our definition of ‘‘small’’ on the fact that in the
US, for a typical stock a ‘‘small’’ earnings surprise can be roughly defined as within two cents of the
consensus. The median stock price of US firms in our sample is $15, and 0.13% = 0.02/15. In Table 7,
column 3, we use an alternative metric to define a ‘‘small earnings surprise’’. We follow Silverman
(1986) and Scott (1992) (see also Degeorge et al., 1999; Dichev and Skinner, 2002) who suggest a
bin width of 2(IQR)n�1/3 where IQR is the sample interquartile range of the variable and n is the num-
ber of observations. An observation qualifies as a ‘‘small earnings surprise’’ if it falls within ±1 bin
around zero.

The Spearman rank correlation of the ratio of small positive to small negative surprises with the
country measure of Finance-Aggregate is 0.33 or 0.38, depending on our definition of small surprises
(p-values 0.14 and 0.09 respectively). Therefore, the link between financial development and analyst
consensus fixation seems weak at best.

Table 5
Panel firm fixed-effects regression – Earnings management, analyst coverage, and financial system development – All continuous
variables are demeaned and scaled by their S.D.

Analyst coverage = ln[1 + # of
analysts]

Analyst coverage = lag ln[1 + # of
analysts]

(1) (2)
b/t b/t

Analyst coverage in low-FD countries 0.611 0.390
(0.421) (0.761)

Analyst coverage in medium-FD countries �0.722** �0.741**
(0.000) (0.001)

Analyst coverage in high-FD countries �1.122*** �1.114***
(0.002) (0.001)

Control variables Included Included
Firm fixed effects Included Included
Year fixed effects Included Included

Number of observations 65,799 63,113
F 30.925 27.951
Prob > F 0 0
R-square 0.405 0.405
Adjusted R-square 0.257 0.258

t-Statistic for a one-sided test that
a1 + a3 < a1 + a2

3.255 2.916

p-Value 0.000 0.000

t-Statistic for a one-sided test that

a1 + a2 < a1 2.122 2.921

p-Value 0.000 0.000

The dependent variable is EM Activity. In this table, EM activity for each observation is centered on the country mean and scaled
by the standard deviation of EM activity at the country level. Column 1 reports the results of the basic model, in which Analyst
Coverage is measured as ln(1 + number of analysts following the firm). In column 2 we use the 1-year lagged value of
ln(1 + number of analysts following the firm) as our instrument for Analyst Coverage. All measures of analyst following are
centered on the country mean and scaled by the standard deviation of analyst activity measure at the country level. We sorted
countries into three categories of financial development (high FD, medium FD, low FD) based on the Finance-Aggregate measure
of Beck and Levine (2002). Medium FD (respectively High FD) is a dummy variable equal to one if the company is from a
medium-FD country (resp. high-FD country), and zero otherwise. Control variables (output not tabulated for the sake of
simplicity) are similar to the control variables presented in Table 2 (ROA, |ROA|, and DROA, Size, Leverage, Growth). ROA, |ROA|,
and DROA are centered on the country mean and scaled by the standard deviation of the variable. We report p-values in
parentheses below the coefficients.
In the last two lines of the table, we report the absolute value of the t statistic and the associated p value for the test of the
difference between a1 + a3 and a1 + a2 (first line), between a1 + a2 and a1 (second line).
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our
sample construction.
� Significant at the 10% level.
** Significant at the 5% level.
*** Significant at the 1% level.

16 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

Table 8 reports average earnings management activity for firms with small negative (column 2) vs.
small positive (column 3) earnings surprises, and the difference (column 4 = column 3 minus column
2). In a country with high analyst consensus fixation, firms should manipulate their earnings to beat
the analyst consensus, and the small positive/small negative earnings management difference should
be high. If high-FD countries exhibit higher analyst consensus fixation, we should find a positive cor-
relation between the number reported in column 4 and financial development. In fact, the Spearman
rank correlation between column 4 and Finance-Aggregate is slightly negative (�0.10) albeit not sta-
tistically different from zero (p-value 0.67).

Overall then, we find little support for the notion that analyst consensus benchmark is more impor-
tant in high-FD countries, casting doubt on the validity of the FD analyst consensus fixation hypoth-
esis. We now turn to an alternative approach that tilts the balance in favor of this hypothesis.

Table 6
Regressions with industry, year and country controls – earnings management, analyst coverage, and financial system development.

Analyst
coverage = ln[1 + # of
analysts]

Analyst coverage = lag
ln[1 + # of analysts]

Analyst
coverage = ln[1 + # of
analysts]
Analyst coverage = lag
ln[1 + # of analysts]

(1) (2) (3) (4)
b/t b/t b/t b/t

Legal enforcement �0.002 �0.003
(0.395) (0.452)

Investor protection �0.002*** �0.001**
(0.001) (0.001)

Medium-FD countries �0.012** �0.009** �0.028 0.021
(0.021) (0.019) (0.291) (0.349)

High-FD countries �0.015** �0.019** �0.012** �0.004**
(0.013) (0.014) (0.021) (0.031)

Analyst coverage 0.002* 0.001 0.006 �0.004
(0.068) (0.813) (0.651) (0.725)

Analyst
coverage � Medium-
FD countries

�0.004 �0.001 �0.004 �0.001

(0.962) (0.111) (0.762) (0.225)
Analyst

coverage � High-FD
countries

�0.003*** �0.004*** �0.002*** �0.004***

(0.000) (0.000) (0.000) (0.000)
Other control variables Included Included Included Included
Country fixed effects Included Included Excluded Excluded
Industry fixed effects Included Included Included Included
Year fixed effects Included Included Included Included

Number of
observations

65,799 63,113 65,799 63,113

F 17.951 17.921 18.251 16.611
Prob > F 0.000 0.000 0.000 0.000
R-square 0.205 0.210 0.171 0.172
Adjusted R-square 0.173 0.166 0.139 0.151

The dependent variable is EM Activity. Columns 1 and 4 tabulate findings for which Analyst Coverage is measured as
ln(1 + number of analysts following the firm). In columns 2 and 4, we use the 1-year lagged value of ln(1 + number of analysts
following the firm) as our instrument for Analyst Coverage. We sorted countries into three categories of financial development
(high FD, medium FD, low FD) based on the Finance-Aggregate measure of Beck and Levine (2002). Medium FD (respectively
High FD) is a dummy variable equal to one if the company is from a medium-FD country (resp. high-FD country), and zero
otherwise. Other control variables include the same control variables as in Table 2 (ROA, |ROA|, DROA, Size, Leverage, Growth).
Investor protection is the anti-director rights index created by La Porta et al. (1998). It is an aggregate measure of minority
shareholder rights and ranges from zero to five. Legal enforcement is developed by Leuz et al. (2003) and is measured as the
mean score across three legal variables used in La Porta et al. (1998): (i) the efficiency of the judicial system, (ii) an assessment
of rule of law, and (iii) the corruption index. All three variables range from 0 to 10. We report p-values in parentheses below the
coefficients.
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our
sample construction.
* Significant at the 10% level.
** Significant at the 5% level.
*** Significant at the 1% level.

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 17

5.2. Earnings close to the consensus

We have not been able to detect a higher level of analyst consensus fixation in high-FD countries.
Let us suppose nevertheless that it is higher in high-FD countries, but in ways that we are not able to
measure. The firms for which the fixation on trying to meet or beat the analyst forecast is likely to be
strongest are those with earnings close to the analyst consensus. Accordingly, in Table 9 we replicate
the previous analysis, now focusing exclusively on firms with earnings close to the consensus, and so
tipping the scales in our analysis in favor of the FD consensus fixation hypothesis. If we find support

Table 7
Analyst consensus fixation across levels of financial development (firms covered by financial analysts).

(1) (2) (3)
Finance-aggregate Ratio of the number of

small positive to the
number of ‘‘small’’
negative earnings
surprises

Ratio of the number of
small positive to the
number of ‘‘small’’
negative earnings
surprises (alternative
definition of ‘‘small’’)

India �0.36 0.91 0.93
Belgium �0.15 0.88 0.92
Denmark 0.07 1.37 1.22
Italy 0.13 1.39 1.25
Finland 0.25 1.58 1.21
Austria 0.43 0.80 0.90
Spain 0.49 0.96 0.93
Norway 0.59 1.15 1.08
France 0.69 1.06 0.97
South Korea 0.70 1.62 1.65
Australia 0.92 1.17 1.21
Canada 0.92 1.52 1.59
Sweden 0.94 1.23 1.32
Germany 0.95 1.29 1.19
Malaysia 0.95 0.98 1.11
Great Britain 0.96 1.77 1.52
South Africa 1.08 1.06 0.99
Netherlands 1.18 1.56 1.41
USA 1.44 2.61 2.32
Singapore 1.51 1.23 1.19
Japan 1.73 1.07 1.09

Spearman rank correlation
with Finance-aggregate

0.33 0.38

p-Value 0.14 0.09

In column 1 we rank countries by increasing level of financial development according to the Finance-Aggregate measure of Beck
and Levine (2002). Column 2 reports the ratio of small positive to small negative surprises by country. Earnings surprise equals
reported EPS, minus consensus forecast, divided by the share price 7 days before the earnings announcement date. We classify
an earnings surprise as small if its absolute value is less than 0.13% of the stock price. Column 3, reports an alternative measure
of the ratio of small positive to small negative surprises by country. We follow Silverman (1986) and Scott (1992) (see also
Degeorge et al., 1999; Dichev and Skinner, 2002) who suggest a bin width of 2(IQR)n�1/3 where IQR is the sample interquartile
range of the variable and n is the number of observations. An observation qualifies as a ‘‘small earnings surprise’’ if it falls within
±1 bin around zero.

18 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

for the hypothesis in this setting, it means that the FD consensus fixation effect exists, but it is con-
fined to a subsample of firms close to the analyst consensus; for other firms, the FD enhancement ef-
fect prevails. If we cannot find support for the FD fixation hypothesis in this setting, then we must
conclude that it is simply not supported by the evidence.

Table 9 shows that even for firms with earnings close to the consensus (i.e., with a small earnings
surprise, see definition in Table 7), for all specifications, the coefficient on Analyst Coverage in High-FD
countries is always negative (ranging from �0.003 to �0.005) and significant at the 1% level, whereas
coefficients on Analyst Coverage in other FD levels (low or medium) are generally not. In other words,
an increase in within-firm analyst coverage is associated with less earnings management only high-FD
countries. The coefficient estimates are close to those of Table 2. This finding goes directly against the
FD fixation hypothesis.

6. Relation of our findings to the literature and conclusion

Rajan and Zingales (1998) find that financial development is especially important for firms that de-
pend on external financing for their growth. Their logic is that these are the firms for which moral haz-
ard and adverse selection problems are likely to be the most severe. We find that financial analysts are

Table 8
Average EM Activity for firms with small earnings surprises.

(1) Finance-
aggregate

(2) Average EM activity
firms with small
negative earnings
surprises (%)

(3) Average EM activity
firms with small positive
earnings surprises (%)

(4) Mean difference
(small positive minus
small negative) (3)
minus (2)

India �0.36 5.72 6.29 0.57%
Belgium �0.15 4.04 3.75 �0.30%
Denmark 0.07 3.35 4.56 1.21%
Italy 0.13 5.08 4.10 �0.99%
Finland 0.25 5.92 5.63 �0.30%
Austria 0.43 3.77 7.27 3.49%
Spain 0.49 4.65 5.32 0.67%
Norway 0.59 3.22 5.25 2.04%
France 0.69 4.82 5.04 0.22%
South Korea 0.70 6.58 2.40 �4.18%
Australia 0.92 4.37 4.79 0.42%
Canada 0.92 4.87 4.64 �0.23%
Sweden 0.94 6.02 3.61 �2.41%
Germany 0.95 4.89 5.68 0.79%
Malaysia 0.95 4.58 4.47 �0.10%
Great Britain 0.96 4.98 4.71 �0.27%
South Africa 1.08 4.56 4.59 0.04%
Netherlands 1.18 5.13 6.96 1.82%
USA 1.44 4.24 4.40 0.16%
Singapore 1.51 5.36 5.02 �0.34%
Japan 1.73 2.86 2.97 0.11%

Spearman rank
correlation
with
finance-
aggregate

�0.10

p-Value 0.67

In column 1 we rank countries by increasing level of financial development according to the Finance-Aggregate measure of Beck
and Levine (2002). Column 2 reports the average earnings management activity for firms with small negative surprises. Column
3 reports the average earnings management activity for firms with small positive surprises. Column 4 reports the difference
column 3 minus column 2.

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 19

more effective monitors in high-FD countries. The greater effectiveness of financial analysts in high-FD
countries may facilitate companies’ access to outside finance. Hence, a two-way relationship may exist
between financial development and the effectiveness of monitoring by analysts. Financial develop-
ment promotes the effectiveness of analyst monitoring. In turn, the quality of analyst monitoring fos-
ters financial development by facilitating firms’ access to outside finance. Our results show the
heterogeneity of financial development (e.g., within Europe) has an impact on the effectiveness of ana-
lysts’ monitoring function even after controlling for other firm fixed effects.

In a related study, Wurgler (2000) finds that countries with developed financial sectors increased
their investment more in growing industries and decreased their investment more in declining indus-
tries. To the extent that financial analysts in high-FD countries provide better monitoring, they offer
better guidance to investors as to the growth prospects of firms, and thus may have contributed to this
result.

Our results suggest that financial development and analyst monitoring are complements. Doidge
et al. (2007) find that country-level investor protection and firm-level governance are complements.
To the extent that financial development is closely correlated with investor protection – and the typ-
ical measures of financial development and investor protection do exhibit such a positive correlation
(see Beck et al., 2003; Beck and Levine, 2005) – our findings are consistent with theirs.

Morck et al. (2000) find that poorly developed stock markets are poor processors of firm-specific
information. The pattern we document in our study – an inability of financial analysts to prevent earn-
ings management in low-FD countries – may contribute to the phenomenon identified by Morck et al.

Table 9
Panel firm fixed-effects regression – earnings management, analyst coverage, and financial system development (firms with small
earnings surprises) a1.

Panel A: OLS panel firm fixed-effects
regressions

Panel B: WLS panel firm fixed-effects
regressions

Analyst
coverage = ln[1 + #
of analysts]
Analyst
coverage = lag
ln[1 + # of analysts]
Analyst
coverage = ln[1 + #
of analysts]
Analyst
coverage = lag
ln[1 + # of analysts]
(1) (2) (3) (4)
b/t b/t b/t b/t
a1 Analyst coverage in
low-FD countries

0.017* 0.009 0.021** 0.008

(0.065) (0.109) (0.038) (0.250)
a1 + a2 Analyst coverage

in medium-FD
countries

�0.003 �0.002 0.001 �0.004

(0.218) (0.266) (0.939) (0.198)
a1 + a3 Analyst coverage

in high-FD countries
�0.003*** �0.005*** �0.003*** �0.005***

(0.000) (0.000) (0.021) (0.000)
ROA 0.000 0.000 0.000 0.000

(0.426) (0.400) (0.227) (0.224)
|ROA| 0.000** 0.000*** 0.000** 0.000**

(0.018) (0.011) (0.027) (0.029)
Change in ROA 0.000 0.000 0.000 0.000

(0.198) (0.427) (0.139) (0.228)
Size �0.002*** �0.001** �0.002*** �0.002**

(0.004) (0.027) (0.010) (0.032)
Leverage 0.001** 0.001** 0.000 0.000

(0.033) (0.021) (0.197) (0.231)
Growth 0.061*** 0.052*** 0.066*** 0.055***

(0.000) (0.001) (0.000) (0.000)
Firm fixed effects Included Included Included Included
Year fixed effects Included Included Included Included

Number of observations 21,081 20,882 19,546 19,546
F 10.848 12.535 7.953 9.267
Prob > F 0.000 0.000 0.000 0.000
R-square 0.500 0.515 0.483 0.484
Adjusted R-square 0.285 0.286 0.240 0.242

For firm i in country j in year t: EM Activityijt ¼ a0 þ a1 Analyst Coverageijt þ a2 Analyst Coverageijt � Medium FDj þ a3 Analyst
Coverageijt � High FDj þ a4 Control variablesijt þ eijt .

The dependent variable is EM Activity. We restrict the analysis to firms with small earnings surprises. We classify an earnings
surprise as small if its absolute value is less than 0.13% of the stock price. Column 1 reports the results of the basic model, in
which Analyst Coverage is measured as ln(1 + number of analysts following the firm). In column 2 we use the 1-year lagged
value of ln(1 + number of analysts following the firm) as our instrument for Analyst Coverage. Columns 3 and 4 replicate
columns 1 and 2 with a WLS regression. We sorted countries into three categories of financial development (high FD, medium
FD, low FD) based on the Finance-Aggregate measure of Beck and Levine (2002). Medium FD (respectively High FD) is a dummy
variable equal to one if the company is from a medium-FD country (resp. high-FD country), and zero otherwise. ROA, |ROA|, and
DROA are, respectively; the Return on Assets, the absolute value of ROA, and the change in ROA. Size ranges from 1 to 10,
corresponding to the decile (1: lowest; 10: highest) of total assets for the firm-year. Deciles are computed country by country.
Leverage is the ratio of total debts to total assets. Growth is the mean annual GDP growth rate per country. We report p-values
in parentheses below the coefficients.
Appendix A defines the variables. Appendix B explains the calculation of the EM Activity variable. Appendix C explains our
sample construction.
* Significant at the 10% level.
** Significant at the 5% level.
*** Significant at the 1% level.

20 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 21

Our study relies on the use of short-term discretionary accruals. We recognize the limitations of
using this metric to capture earnings management. It is possible that earnings management is not pri-
marily done via short-term accruals in some countries. Recently, Higgins (2013) showed earnings
management via long-term accruals by Japanese companies. More broadly, the Jones (1991) and mod-
ified Jones (Dechow et al., 1995) models have been criticized for their lack of power and their possible
misspecification (see, e.g., McNichols, 2000; Collins et al., 2011). We acknowledge that the literature
has identified other measures of earnings management: total discretionary accruals, specific accruals
and discontinuities in frequency distributions (Burgstahler and Dichev, 1997; Degeorge et al., 1999;
McNichols, 2000). However, as Section 3.2 makes clear, a dominant stream of literature highlights
the role of short-term discretionary accruals in earnings management and motivates our use of this
metric.

Our study focuses on accounting-based earnings management. An interesting extension of our
work would be to examine whether our results also extend to other forms of earnings management,
such as cash-based earnings management (Jian and Wong, 2010) or real earnings management (Cohen
et al., 2008; Cohen and Zarowin, 2010).19

We focus on an important class of agents in the financial intermediation process: financial analysts.
We find that analyst monitoring is more effective in more financially developed countries. Using a
sample of 65,799 firm-year observations in 21 countries from 1994 to 2002, we find that the higher
the financial development of a country, the greater the reduction in earnings management associated
with analyst coverage. In high-FD countries, as within-firm analyst coverage moves from zero to one,
earnings management activity falls by about 5%. Our findings are robust to reverse causality checks.
According to Levine (1997), ‘‘financial contracts, markets, and intermediaries may arise to mitigate
the information acquisition and enforcement costs of monitoring managers.’’ We find empirical sup-
port for this claim.

Acknowledgements

We thank Charles Chen, François Derrien, Pascal Dumontier, Claude Francoeur, Francesco Franz-
oni, Patrick Gagliardini, Ferdinand Gul, Peter Joos, Michel Magnan, Sébastien Michenaud, Neale
O’Connor, Myron Slovin, Bin Srinidhi, Alexander Stomper, Xijia Su, Stéphane Trébucq, Alfred Wagen-
hofer, Alexander Wagner, Kent Womack, two anonymous reviewers and seminar and conference
participants at City University of Hong Kong, Korea University, Katholieke Universiteit Leuven, Mon-
ash University, University of Graz, University of Frankfurt, University of Luxemburg, Université
Paris-Dauphine, the BSI Gamma Foundation Conference, the Third International Conference on
Governance and Forensic Accounting, EAA, and AAA, for helpful comments and discussions. We
acknowledge support from the HEC Foundation (projects F0802 and F1102) and from the Research
Alliance in Governance and Forensic Accounting, funded within the Initiative on the New Economy
program of the Social Sciences and Humanities Research Council of Canada (SSHRC). We also thank
the BSI Gamma Foundation for research support. Part of this research was carried out within the
project on Corporate Finance of the National Centre of Competence in Research ‘‘Financial Valuation
and Risk Management’’ (NCCR FINRISK). The NCCR FINRISK is a research program supported by the
Swiss National Science Foundation. François Degeorge gratefully acknowledges support from the
Swiss National Science Foundation ProDoc Program PDFMP1_126390. Yuan Ding gratefully acknowl-
edges funding support from the CEIBS Research Division and the generous support of Jiangsu Jinsh-
eng Industry Co., Ltd. The data on analysts’ forecasts of earnings were provided by the Institutional
Brokers Estimate System (I/B/E/S), a service of Thomson Financial, as part of a broad academic pro-
gram to encourage earnings expectations research. Hervé Stolowy is a member of the GREGHEC,
CNRS unit, UMR 2959.

19 On the pros and cons of various measures of earnings management, see McNichols (2000) and Peasnell et al. (2000).

22 F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25

Appendix A. Variable definitions

Variables

Definitions
EM activity
Absolute value of short-term discretionary accruals (Jones, 1991;
Teoh et al., 1998a, 1998b) (see Appendix B for details of the
computation)
Analyst coverage
Ln(1+# analysts) in the baseline model (data source: I/B/E/S)

FD

Financial development: Finance-Aggregate measure, as defined by

Beck and Levine (2002)
Analyst

coverage � Financial
development

Interaction variable between Analyst coverage and Financial
development. The 21 countries were divided into three terciles of
Financial development – Lower, Medium, and High – using a k-
means cluster analysis

Medium-FD
Dummy variable equal to one if the company is in a country of
medium financial development, and zero otherwise
High-FD
Dummy variable equal to one if the company is in a country of high
financial development, and zero otherwise

Controls

Control variables:

ROA

Return on Assets (data source: Global Vantage)

|ROA|

Absolute value of ROA (data source: Global Vantage)

DROA

Change in ROA (data source: Global Vantage)

Size

Ranges from 1 to 10, corresponding to the decile (1: lowest; 10:

highest) of total assets for the firm-year. Deciles are computed
country by country (data source: Global Vantage)

Leverage
Ratio of total debts to total assets (data source: Global Vantage)

Growth

Mean annual GDP growth rate per country (data source: World

Bank Development Indicators)

Appendix B. Computation of our earnings management measure

Accruals are adjustments to the cash-flow to generate net earnings:

Earningst ¼ cash flowt þ accrualst ð3Þ

Accruals may have legitimate accounting purposes: for example, depreciation allowances may be
booked to reflect the ageing of assets. But accruals may also be used inappropriately to manage com-
panies’ earnings. The challenge for the researcher is to disentangle the legitimate, non-discretionary
portion of accruals from its discretionary part:

Accrualst ¼ discretionary accrualst þ non-discretionary accrualst ð4Þ

There are two constituents of total accruals:

(1) Long-term accruals relate to the recognition of depreciation expense in the income statement.
(2) When the income statement records sales instead of cash revenues, there is a corresponding

change in receivables. When the income statement records expenses instead of cash outflows,
there are corresponding changes in inventories and current liabilities. These adjustments
(change in non-cash current assets minus change in operating liabilities) are labeled short-term
(or current) accruals. As explained by Sloan (1996, p. 297), the majority of the variation in accru-
als is attributable to variation in the current asset component. Teoh et al. (1998b) consider cur-
rent accruals and long-term accruals separately because accounting researchers (e.g., Guenther,
1994) have argued that managers have greater discretion over current accruals than over long-
term accruals.

F. Degeorge et al. / J. Account. Public Policy 32 (2013) 1–25 23

We use two-digit GICS codes to compute the country-year-industry specific a, and b in the follow-
ing Eq. (5):

STAcc;ind;t
TAc;ind;t�1

¼ ac;ind;t �
1

TAc;ind;t�1
þ bc;ind;t �

DSalesc;ind;t
TAc;ind;t�1

þ ec;ind;t ð5Þ

Subscripts t and i refer, respectively, to time and to firm. STAc refers to ‘‘short-term accruals’’ (change
in non-cash current assets minus change in operating liabilities), TA refers to ‘‘total assets,’’ c, ind and t
are respectively country, industry, and year specific, DSales stands for ‘‘change in net sales,’’ e is the
error term. Since e is heteroskedastic, we scale all variables by lagged total assets.

a, and b are country, year, and industry specific. Following Jones (1991) and Dechow et al. (1995),
we compute expected accruals by combining real data for the firm (DSales) with the estimated coef-
ficients (a and b) of the previous year, as in Eq. (5). Thus, expected short-term accruals represent an
estimate of the normal level of short-term accruals for a firm, given its size and industry. We then de-
fine short-term discretionary accruals (SDAit) as the difference between actual short-term accruals and
predicted short-term accruals:

SDAit ¼
STAci;t
TAi;t�1

� ac;ind;t�1 �
1

TAi;t�1
þ bc;ind;t�1 �

DSalesi;t
TAi;t�1|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}

Expected accruals for i in year t

2
6664

3
7775 ð6Þ

Appendix C. Sample construction

Our initial sample consists of all non-financial firms with sufficient data to compute discretionary
accruals and belonging to the countries included in Beck and Levine (2002). This leads to an initial
sample of 76,430 observations from 42 countries. We apply a number of filtering rules to our initial
sample:

(1) We drop countries with less than 150 observations of short-term accruals. We lose 12 countries
and 1422 observations.

(2) Following DeFond and Jiambalvo (1994), we drop industries with less than 7 observations. We
lose 1359 observations.

(3) We drop countries with observations in less than 5 of the years 1994–2002 and in less than 5
industries. We lose 6507 observations and 9 countries.

(4) Following Subramanyam (1996), we drop observations with total accruals in excess of the top
or bottom 1% of the fitting sample. We lose 1343 observations.

At the end of this process we are left with a sub-sample of 65,799 firm-year observations on 21
countries.

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• Analyst coverage, earnings management and financial development: An international study

1 Introduction
2 Hypothesis development
3 Research design
3.1 Methodology
3.2 Sample and data
4 Empirical findings
4.1 Univariate findings
4.2 Multivariate findings
4.3 Robustness checks
5 A closer look at the FD analyst consensus fixation hypothesis
5.1 Analyst consensus fixation is not higher in high-FD countries
5.2 Earnings close to the consensus
6 Relation of our findings to the literature and conclusion
Acknowledgements
Appendix A Variable definitions
Appendix B Computation of our earnings management measure
Appendix C Sample construction
References

52 Academy of Management Perspedives August

S Y P O S I U

Political Markets and Regulatory Uncertainty:
Insights and Implications for Integrated Strategy
by Allison F. Kingsley, Richard G. Vanden Bergh, and Jean-Philippe Bonardi

Executive Overview
Managers can craft effective integrated strategy by properly assessing regulatory uncertainty. Leveraging the
existing political markets literature, we predict regulatory uncertainty from the novel interaction of
demand- and supply-side rivairies across a range of political markets. We argue for cwo primary drivers of
regulatory uncertainty: ideology-motivated interests opposed to the firm and a lack of competition for
power among political actors supplying public policy. We align three previously disparate dimensions of
nonmarket strategy—profile level, coalition breadth, and pivotal target—to levels of tegulatory uncer-
tainty. Through this framework we demonstrate how and when firms employ different nonmarket strategies.
To illustrate variation in nonmarket strategy across levels of regulatory uncertainty, we analyze several
market entry decisions of foreign firms operating in the global telecommunications sector.

F
irms know that entering a new industry or
geographic market involves market risk. Com-
mitting to that investment may also suhject

flrms to a critical nonmarket risk: regulatory un-
certainty. Firms entering new markets are often
required to gain approval from a regulator, and
once approved the firm’s investments are typically
suhject to ongoing scrutiny hy a regulator over
issues such as product safety, pricing, rate of re-
turn, competition, and access to distrihution
channels. The uncertainty associated with
changes in regulation or public policy can reduce
the firm’s profitability or block the firm from
meeting other performance objectives.

This applies, of course, to developed countries
but also to emerging economies. Consider for in-
stance the case of the German wholesaler Metr

o

Cash and Carry when it enteced India in 200

3

(Khanna, Palepu, Knoop, & Lane, 2009). Al-
though Metro’s distribution processes could be of
value in India, where getting fresh fruits and veg-
etables was often challenging for local restaurants
and hotels, the firm struggled to obtain regulatory
approval. Several years after obtaining initial reg-
ulatory approval to enter the market, shelves in
Metro’s large stores were still half-empty because
of local governments’ interpretation of the Agri-
cultural Produce Marketing Committee Act. This
act, in effect, prevented the company from sourc-
ing from farmers directly. Metro also faced much
stronger local opposition, particularly from local
retailers, than it had expected. Overall, regulatory
uncertainty was the major reason a multinational
like Metro struggled in India.

In a similar spirit, more than 300 multinational
executives from diverse firms, industries, and host

* Allison F. Kingsley (altison.kingstey@uvn.edu) is Assistant Professor of Management at the University of Vermont School of Business
Administration.
Richard G. Vanden Bergh (vandenbergh@bsad.uvm.edu) is Associate Professor of Management at the University of Vermont School of
Business Administration.
Jean-Philippe Bonardi (jean-phitippe.b0r3rdi@unit.ch) is Professor at the Faculty of Business and Economics of the University of
Lausanne.

Copyright of the Academy of Manogement, all rights reserved. lontents may not be copied, emoiled, posted to a listserv, or otherwise tronsmitted without the copyright holder’s express written permission.
Users may print, downlood, or email articles for individuol use only. http://dx.doi.org/10.5465/amp.2012.0042

2012 Kingsley, Vanden Bergh, and Banardi 53

countries were asked in July 2011 to assess the
salience of political risks in their emerging market
investments (World Bank, 2011). Among the re-
spondents, 54% rated adverse regulatory change as
a political risk of most concem, a significantly
more pressing concem than either risk of expro-
priation (34%) or risk of war (31%). About one in
five executives regarded war (23%) and expropri-
ation (18%) risk as having “no impact” on their
risk perception; fewer than 1 in 25 regarded reg-
ulatory uncertainty as such (3%). Indeed, 35% of
multinational companies have experienced finan-
cial losses in the past three years due to adverse
regulatory changes. In the past 12 months alone,
43% of surveyed multinationals withdrew existing
or canceled planned investments due to unfavor-
able changes in regulation. To manage ongoing
investments with regulatory uncertainty, execu-
tives closely monitor the risk (27%) but also find
that the most effective strategy relies on engaging
with local public entities (10%), local enterprises
(14%), or key political leaders (25%). Nonmarket
strategies matter to executives. When firms fail to
align nonmarket strategies to the regulatory un-
certainty they face, struggles like those experi-
enced by Metro Cash and Carry in India occur.

Understandably, both market and regulatory un-
certainty will vary from one industry or geographic
region to the next but are not exclusive to any one
industry or region. Thus firms need to develop an
understanding of the key factors affecting both types
of uncertainty, and from this understanding craft an
integrated strategy (Baron, 1995a, 1995b) that min-
imizes the costs associated with the regulatory un-
certainty while complementing the firm’s market
investments. Crafting strategy to manage market
uncertainty is important and highly developed in the
business field. In this paper we focus our analysis on
designing nonmarket strategies to manage regulatory
uncertainty and discuss ways for firms to integrate
this with their market strategy. Our empirical con-
text centers on firms’ market entry strategies, al-
though our analysis can be applied across multiple
market strategies.

We propose a practical and novel framework
for managers to predict the level of regulatory
uncertainty. The framework we develop builds
from what are referred to as “political markets,” a

term first coined by Nobel laureates in economics
James Buchanan and Gordon TuUock (1962) and
later applied to the study of firms’ nonmarket
activities (Bonardi, Hillman, & Keim, 2005). Ac-
cording to the framework, political markets con-
sist of demanders of public policy such as firms,
consumers, and special-interest groups. Demand-
ers have a stake in regulatory policy. For example,
a firm’s stake reflects the incremental effect a
regulation will have on profitability, while a con-
sumer’s stake reflects the effect a regulation will
have on the value-to-price ratio of the product.
Political markets also consist of suppliers of public
policy such as legislators and the executive, regu-
lators, and courts. Similar to demanders, suppliers
also have interests in regulatory outcomes. Sup-
plier interests, in contrast to firms’, are assumed to
reflect their own ideology and/or the interests of
their constituents (Kalt & Zupan, 1984).

Demanders and suppliers interact with each
other by exchanging information, votes, and/or
other valuable resources. Erom this exchange be-
tween demanders and suppliers a regulatory policy
emerges; predicting the level of regulatory uncer-
tainty, however, remains elusive. Whereas the po-
litical market approach has already been used to
study firms’ ability to influence policy-making, we
propose that a similar approach can be used to
predict regulatory uncertainty and how firms can
manage the regulatory uncertainty through the
design of an integrated strategy.

In jointly analyzing political markets and regula-
tory uncertainty, we make several meaningful con-
tributions. We provide a flexible framework that
applies to the range of nonmarket settings by trans-
lating the political markets framework developed in
more mature and formal institutional settings (e.g.,
the United States and Westem Europe) to the
emerging-market and developing-country context.
Specifically, we analyze the supply-side interaction
among multiple political actors, including autocratic
sovereigns. We also develop new insights into the
key characteristics of demand-side interest groups.
Eurthermore, we explore how the characteristics of
both the demand- and supply-side actors interact
with each other to affect the degree of regulatory
uncertainty a firm faces.

We offer an innovative perspective on the

54 Academy af Management Perspetiives August

three dimensions of firms’ nonmarket strategies,
effectively synthesizing several previously dispa-
rate nonmarket choices. In addition, we integrate
this nonmarket analysis with one of a firm’s most
critical market strategies: market entry. In show-
ing how firms can assess regulatory uncertainty in
the context of entering new markets, we contrib-
ute to several literatures on market, nonmarket,
and integrated strategy. In addition, our insights
on nonmarket strategies offer managers clear, ex-
ecutable strategies with direct overall performance
implications for firms.

The paper is organized as follows. Overall we
propose a simple two-by-two framework in two parts.
In the “Political Markets and Regulatory Uncer-
tainty” section, we develop the first part of the
framework, which derives predictions about regula-
tory uncertainty. In the ‘TSIonmarket Strategies” sec-
tion, we propose the second part of the framework,
which develops strategic implications for firms to
manage regulatory uncertainty in the context of
their expected and/or existing market investments.
To create an integrated strategy, we suggest the
dimensions of a nonmarket strategy that fit well with
the characteristics of the political market, that is,
activities and tactics in which market decisions such
as market entries are aligned with nonmarket ones
such as campaign contributions, lobbying, or coali-
tion building (Baron, 1995a; de Figueiredo &. Ed-
wards, 2007; Hillman & Hitt, 1999). In the “Discus-
sion” section, we provide various examples from
firms’ market entry choices in the global telecom-
munications sector that involve different nonmarket
strategies; we argue that the observed integrated
strategy fits well with our framework. Finally, in the
“Gonclusions” section, we discuss our contribution
and the critical open questions that need to be
addressed to develop a deeper understanding of reg-
ulatory uncertainty and the implications for firms as
they develop their integrated strategy.

Political Markets and Regulatory Uncertainty

P
olitical markets are different from economic
markets (Boddewyn &. Brewer, 1994; Bonardi
et a l , 2005; Bonardi, 2011; Buchanan & TuU-

ock, 1962; Hillman & Keim, 1995; Weingast &
Marshall, 1988). This is why managers pursue
market strategies to improve the firm’s economic

performance and nonmarket strategies to improve
the firm’s political performance. For the best over-
all firm performance, managers integrate market
and nonmarket strategies (Bach &. Allen, 2010;
Baron, 1995a, 1995b). In this section of the paper,
we focus mainly on the nonmarket environment
of business, specifically the political market for
regulation, and we analyze a key nonmarket issue
confronting managers: regulatory uncertainty.

The magnitude of regulatory uncertainty is
critical to the performance of firms in many in-
dustries, including oil, natural gas, electric utili-
ties, airlines, pharmaceuticals, and telecommuni-
cations. Research has shown that heavily
regulated (e.g., banking, telecommunications, nu-
clear power) and government-dependent (e.g., de-
fense) industries necessarily spend the most cor-
porate resources managing regulatory uncertainty
(Baron, 1995a; Goates, 2011; Grier, Munger, &.
Roberts, 1994; Stigler, 1971). However, the re-
cent growth of social and environmental interest
groups has spread regulatory uncertainty to indus-
tries not traditionally considered highly regulated
(Holbum & Vanden Bergh, 2008; King & Lenox,
2000). Such uncertainty is difficult for business
(Ryan, Swanson, &. Buchholz, 1987), and execut-
ing nonmarket strategies is increasingly seen as
“the cost of doing business” (Kwak, 2012). That
cost derives in part from regulators’ leaming
curve—their need to learn how to regulate new
business models and/or technologies—and from
the political games taking place among the various
players involved in the regulatory process, such as
firms, regulators, politicians, consumers, and in-
terest groups (Holbum & Vanden Bergh, 2004,
2008). Whereas authors in the international busi-
ness literature typically have focused on the bar-
gaining power of multinational firms vis-à-vis lo-
cal govemments (Blumentritt & Rehbein, 2008;
Lecraw, 1984; Luo & Zhao, in press), we consider
here the interactions among a much larger poten-
tial set of institutional players.

Managers will find it useful to view regulation
in the context of a political market where there
are demanders of regulation and suppliers of regu-
lation. See Figure 1 for an illustration. As expli-
cated in the introduction of this paper, demanders
are the regulated firm, other firms, consumer

2012 Kingsley, Vanden Bergh, and Banardi 55

Figure 1
Political Markets, Regulatory Uncertainty, and Integrated Strategy

Rivalry faced by the
focal firm on the
DEMAND SIDE of the
political market
(interest groups,
activists, other firms)

Political Market Conditions

REGULATORY
UNCERTAINTY

Rivalry among public
players on the SUPPLY
SIDE of the political
market (regulators,
politicians, courts)

Focal Firm’s
Integrated Strategy

groups, and other activist interests or stakeholders
(Arrow, 1951; Black, 1958; Buchanan & TuUock,
1962); suppliers are the regulator, the executive,
legislators, political parties, and courts (Downs,
1957; Riker, 1962; Stigler, 1971). Demanders and
suppliers transact by trading regulatory policies for
resources such as votes, finances, or information
(de Eigueiredo & Edwards, 2007; Hillman & Hitt,
1999). Eirms can be strategic with political market
transactions to maximize firm performance.

Indeed, the political market matters for firms.
Scholars have shown that the nature of demand-
ers can influencé the regulatory process. Eor ex-
ample, in the electric utility sector regulators tend
to reduce the allowed rates charged to consumers
when a competing interest group advocates for
consumers within the political market (Bonardi,
Holbum, & Vanden Bergh, 2006). Researchers
have also shown that the nature of suppliers
shapes regulatory outcomes. In the political econ-
omy literature, for example, scholars have shown
that elected regulators tend to have a negative
effect on tiie profitability of firms (Besley &.
Coate, 2003). There are thus factors in the polit-
ical market that tend to bias regulation in predict-
able directions. However, there are also factors
that create greater uncertainty for firms subject to
regulation over their market investments.

To predict the relative magnitude of regulatory
uncertainty, managers must understand their spe-
cific political market context, notably the nature
of demand-side rivalry and the nature of supply-
side rivalry. Drawing from the political markets

literature we focus on two drivers of regulatory
uncertainty: political motivation/level of ideology
(on the demand side) and level of competition for
power among political decision makers (on the
supply side). Eurthermore, we argue that this reg-
ulatory uncertainty makes political markets less
attractive for business investment.

Nature off Demand-Side Rivalry

The political markets literature identifies demanders
of regulation as firms in the industry, consumer
groups affected by regulatory policy, and other activ-
ist interest groups with a stake in the policy outcome
(Bonardi et al., 2005; Hardin, 1982; Moe, 1980;
Olsen, 1965). Demanders can originate locally or
intemationally. In developing-country contexts, ex-
ternal or foreign interests tend to assume a larger
role, capitalizing on foreign firms’ vulnerabilities
and/or vocalizing local groups’ interests. We exam-
ine regulatory uncertainty from the perspective of
regulated firms, whereby the focal firm is opposed by
either another firm or an interest group representing
stakeholders or affected interests. The firm’s rival on
the demand side is characterized by its motivation
for regulatory change, either ideology or efficiency
motivations.

Ideology-motivated interests generate the most
regulatory uncertainty. Demanders with ideologi-
cal agendas are difficult to manage (Bonardi et al.,
2006; Bonardi & Keim, 2005) and tend to lever-
age public pressure effectively through tactics such
as mailings, campaigns, boycotts, reports, and/or
advocacy advertising (Baron, 2010; Holbum &

56 Academy oí Management Perspectives August

Vanden Bergh, 2004). Nonmarket issues that
have an ideological underpinning also tend to be
uniquely partisan and widely salient, which corre-
lates with more unattractive political markets
(Bonardi et a l , 2006; Bonardi & Keim, 2005).
Intensified rivalry among competing demanders
makes markets even more unattractive. Research
finds that rivalry increases with election issues,
concentrated costs or benefits, and attempts to
change existing regulation (Bonardi et al., 2005;
Bonardi et al., 2006; Bonardi & Keim, 2005; Hill-
man &. Hitt, 1999; Lowi, 1964; Wilson, 1980), all
of which arguably accompany ideological opposi-
tion. In addition, the coalition of voter interests
tied to ideology-motivated opponents likely holds
more strongly felt preferences with greater indi-
vidual stakes, and thus they make more durable
opponents than efficiency-motivated interests
(Stigler, 1971; Weingast & Marshall, 1988).

Efficiency-motivated interests, by contrast, tend
to be associated with narrower issues that are not
defined along partisan lines but rather reflect bot-
tom-line concerns. With efficiency-motivated ri-
vals, the regulated firm is better able to identify
rivals and has more substitute actions available to
trade, which, in tum, lowers transaction costs of
negotiation relative to ideology-motivated rivals
(Coase, 1960). Thus, from the regulated firm’s
perspective, the political market is more attractive
(Bonardi et al., 2006) when there is less intense
rivalry among demanders (Bonardi et al., 2005;
Bonardi et al., 2006; Bonardi & Keim, 2005) and
less saliency in the eyes of suppliers. All else being
equal, if demand-side rivalry exists, regulatory pol-
icy outcomes are more predictable and regulatory
uncertainty lower when the rival is an efficiency-
motivated interest.

Nature of Supply-Side Rivalry

Suppliers of regulation are the regulator, execu-
tive, legislators, political parties, courts, and other
institutional decision makers. Previous work has
tended to concentrate analysis on select roles. Eor
instance, much of the literature on foreign invest-
ment and bargaining power focuses on only one
aggregate supplier: the host government (Brewer,
1992; Dunning, 1993). In the nonmarket strategy
literature, Bonardi et al. (2005) focused on two

types of suppliers, bureaucrats and elected officials;
Holbum and Vanden Bergh (2004) and Bonardi
et al. (2006) focused on regulatory agencies, rep-
resentatives and senators, and executives; and
Spiller and Gely (1990) and Spiller and Vanden
Bergh (2003) focused on courts. Eollowing this
work, we focus on how the regulator supplies
regulatory policy jointly with politicians.

Competition among political actors creates a
more attractive political market for firms (Anso-
labehere, de Eigueiredo, &. Snyder, 2003; Baron,
2001; Bonardi et al., 2006). Eundamentally this is
because competitive elections increase rivalry
(Bonardi et al., 2006), which makes politicians
more willing to trade policy favors (Baron, 2001)
and more responsive to satisfying constituent in-
terests (Keim & Zeithaml, 1986). As Stigler
(1971, p. 13) noted, “If entry into politics is ef-
fectively controlled, we should expect one-party
dominance to lead that party to solicit requests for
protective legislation but to exact a higher price
for the legislation.” Thus competition among
elected politicians creates opportunities for corpo-
rate political strategies to work (Hillman &. Keim,
1995; Keim &. Zeithaml, 1986), including in a
regulatory setting. We note, however, that in de-
veloped countries such political actors are typi-
cally elected, whereas in developing countries
elections may be less potent or even nonexistent.
There are fewer actors, potentially only one piv-
otal decision maker, less delegation of power from
the executive, and thus signiflcantly less compe-
tition. We incorporate this important distinction
explicitly in our framework.

Competition may be defined beyond rivalry
for power. When competition among political
actors is driven also by heterogeneous prefer-
ences (Bonardi et a l , 2006; Vanden Bergh &.
Holburn, 2007) instead of or in addition to
checks and balances, the logic holds: More com-
petition creates a more attractive (and oppor-
tunistic) political market, which corresponds
with less regulatory uncertainty.

The political markets literature uses several
empirical measures to capture this idea of compe-
tition among political actors. In Bonardi et al.
(2006), the degree of supply-side rivalry is opera-
tionalized as the margin of winning votes for the

2012 Kingsley, Vanden Bergh, and Banardi 57

executive (governor or president) or the legislator
(or party). Rivalry is considered intense if there is
a greater than 5% difference between votes. In.
Holbum and Vanden Bergh (2012), legislative
competitiveness is also measured by the degree of
partisan control of the legislature. Rivalry is most
intense when political parties hold equal shares of
the legislative seats. In addition, a country’s gov-
emance environment has been measured by the
political constraint index (POLCON) compiled
by Henisz (2000) and tested successfully against
intematiorial infrastructure data (2002) and
across a wide range of developed and developing
countries. POLCON measures the feasibility of
policy change based on a simple spatial model of
veto players, party alignment, and preferences
across branches of government.^ The index ranges
from 0 to 1, with higher scores indicating more
political constraints. The more political con-
straints there are, the less feasible policy change
but the more potential leverage or pivot points. In
political markets with no delegation of power
from the executive (e.g., autocratic regimes),
there are no constraints against the executive. In
all measures of political competition, the funda-
mental idea remains the same: Competition
makes political markets more attractive and less
uncertain for the regulated firm.

Predicting Regulatory Policy Uncertainty

I ntegrating these insights on the nature of de-mand-side rivalry and the nature of supply-siderivalry, we can predict regulatory uncertainty.
Figure 2 suinmarizes these insights in the first part
of our simple two-by-two framework.^

Figure 2
Predicting Regulatory Uncertainty

‘ POLCON I measures the feasibility of policy change, that is, the
extent to which a change in the preferences of any one political actor may
lead to a changé in govemment policy. The index is composed from the
following information: the number of independent branches of govemment
with veto power over policy change, counting the executive and the
presence of an effective lower and upper house in the legislature (mote
branches leading to more constraint); the extent of party alignment across
branches of govemment, measured as the extent to which the same party
or coalition of parties controls each branch (decreasing the level of con-
straint); and the extent of preference heterogeneity within each legislative
branch, measured as legislative fractionalization in the relevant house
(increasing constraint for aligned executives, decreasing it for opposed
executives).

We recognize that differences among political markets are more aptly
represented as continua of competition and ideology.

I

Ideology-

Motivated

Opponent(s) I

Efficiency-

Motivated

Opponent(s)

Highly Uncerlairi

“NC/E”

Uncertain

uncertain

“C/l”

“C/E”

Least Uncertain

No Competition Competition
Among Among

Political Actors

Political Actors

NATURE OF SUPPLY-SIDE RIVALRY

Using the insights on regulatory uncertainty
from Figure 2, we can also make predictions about
market entry and implications for investment. If
the regulated firm is opposed by an efficiency-
motivated interest and there is significant compe-
tition among political actors (Cell C/E), there is
less uncertainty. We predict that the regulated
firm will enter the new market, potentially as a
leader (Bonardi et a l , 2005). In hybrid situations
(Cell C/I and Cell NC/E), there is moderate reg-
ulatory uncertainty, which constrains the firm’s
entry decision. If the regulated firm is playing a
political game with an ideology-motivated oppo-
nent in the context of no or little competition
among political actors (Cell NC/I), the regulatory
outcome is highly uncertain. This uncertainty im-
pedes investment, akin to a postpone strategy
(Bonardi et al., 2005). The regulated firm is likely
to not enter a new market (or further invest in an
existing market) if it cannot foresee the value of
its investment over time or anticipate opportuni-
ties to influence the political market. Generally
this results in a net loss for society but may be the
best outcome for the individual firm. Accordingly,
when considering entry into a new market and
when regulatory uncertainty exists, firms have two
stark choices: if uncertainty is too great, delay
investment, or develop and implement a nonmar-
ket strategy that sufficiently mitigates the negative
effects of the uncertainty. We now focus our at-
tention on the latter.

SB Academy af Management Perspedives August

Nonmarket Strategies

D
ifferent types of regulatory uncertainty require
different strategies (Bonardi &. Keim, 2005).
As uncertainty increases so too does the cost

of implementing a nonmarket strategy. We iden-
tify three dimensions previously treated dispa-
rately in the literature to guide how a regulated
firm should allocate incremental resources to mit-
igate uncertainty. The strategies differ in terms of
profile level, coalition breadth, and pivotal tar-
get—and, ultimately, cost. Variation in firm strat-
egies is driven by changes in the nature of both
demand-side and supply-side rivalries, and we ar-
gue that the demand side explains more of the
variation. Eigure 3 summarizes these strategic im-
plications for firms.

Profile Level

Corporate political strategies can be divided into
low- and high-proflle strategies. Low-profile strat-
egies occur without public involvement, whereas
high-profile strategies engage the public. High-
profile strategies are significantly more costly be-
cause the firm needs to invest more in publicity
and runs a greater risk of suffering reputational
damage.

Using the taxonomy of political strategies iden-
tifled in Hillman and Hitt (1999) and further
discussed in Hillman (2003) and Bonardi and
Keim (2005), low-profile strategies include but
are not limited to information strategies such as
lobbying, commissioning research projects and re-
porting research results, and supplying position
papers or technical reports; financial incentive
strategies such as honoraria for speaking and paid
travel; and constituency-building strategies such
as political education programs. High-profile strat-
egies can include information strategies such as
testifying as an expert witness; financial-incentive
strategies such as contributions to politicians and
political parties and personal service (hiring peo-
ple with political experience or having a firm
member run for office); and constituency-building
strategies such as grassroots mobilization (of em-
ployees, suppliers, and customers), advocacy ad-
vertising, public relations, and press conferences.

We can find numerous examples of high-profile

strategies in the literature. They include engaging
in public corporate social responsibility programs
to signal information to consumers and potential
coalition partners (Siegel &. Vitaliano, 2007) as
well as other demanders and suppliers, attending
to political ties and personal relations between the
multinational corporation (MNC) and its host
government (evaluated at length in bargaining
power and political connection theories); strate-
gically increasing political connections between
the firm and high-level govemment officials (Blu-
mentritt, 2003; Blumentritt & Rehbein, 2008;
Dieleman & Boddewyn, 2012; Faccio, 2006; Law-
rence, 2010; Luo &. Peng, 1999); and preemptive
self-regulation (Bonardi &. Keim, 2005; Maxwell,
Lyon, & Hackett, 2000),

Firms tailor the profile of their strategy based
on the nature of opposing demand. For example, if
the firm is opposed by an ideology-motivated in-
terest, it will deploy high-profile political strate-
gies that actively engage the public as well as
political actors. In cases of extreme regulatory
uncertainty (Cell NC/I), the firm will also need
low-profile strategies thai go behind the scenes to
provide information and financial incentives to
key decision makers. With efficiency-motivated
opponents, and thus less uncertainty, the firm
need pursue only low-profile strategies.

Coalition Breadth

Much work on market strategy centers on the
question of corporate scope, whether a firm should
integrate vertically and expand horizontally (Por-
ter, 1985). For nonmarket strategy, the question of
coalition scope can be equally important in deter-
mining performance. Managers must evaluate
whether to build “horizontal” coalitions among
interest groups and stakeholders outside of the
flrm’s “vertical” chain o: production where more
natural coalition partners often reside (Baron,
1995b; Porter, 1985). This vertical rent chain
includes factor inputs (employees, suppliers and
their employees, capital, communities), the value
chain (inbound logistics, operations, outbound lo-
gistics, marketing and saies, service, support activ-
ities, alliances), channels of distribution (whole-
salers, distributors, retailers), and customers
(consumers, locked-in customers) (Baron, 1995b).

2012 Kingsley, Vanden Bergh, and Bonardi 59

Figure 3
Nonmarket Strategies

Ci
lu
g

Q

<

m
a
u.
O
lU

oc

Ideology-
Motivated

Opponent(s)

Efficiency-
Motivated

Opponent(s)

Profile: Low & High

Coalition: Horizontal & Vertical

Pivots’: Regulator, Executive,

Legislators, Party Leaders

“NC/E”

Profile: Low

Coalition: Vertical

Pivots’: Regulator, Party Leaders

iProfile: High

|Coa//i/on; Horizontal

iP/Vofs; Regulator, Executive,
¡

Legislators

“C/I”

“C/E”
Profile: Low
Coalition: Vertical

Pivots: Regulator, Executive,

Legislators

No

Competition Among

Political Actors

Competition Among
Political Actors
NATURE OF SUPPLY-SIDE RIVALRY

*ln extremely uncompetitive
contexts (e.g., strong
autocracy). Pivots: Executive $

Horizontal coalitions can include any interest
group that wants the same regulatory policy out-
come the focal firm seeks.

Our framework helps firms determine the
breadth of their nonmarket coalition based on the
nature of opposing demand. With ideology-moti-
vated opponents, regulated firms must find allies
and advocates outside of their conventional coali-
tion of business-related groups with aligned inter-
ests. This makes horizontal coalitions more costly
to implement. With efficiency-motivated oppo-
nents, firms pursue less costly vertical coalitions.
Situations with the highest uncertainty (Gell
NG/I) require both horizontal and vertical
coalitions.

Pivotal Target

Based on the political markets’ structured models,
demanders will invest incremental resources in
influencing pivotal institutions or actors (Grose-
close, 1996; Groseclose & Snyder, 1996; Holbum
& Vanden Bergh, 2004; Krehbiel, 1998, 1999;
Snyder, 1991).^ The target of the regulated firm’s

•* Because we combine executives and legislatures into one category of
“political actors,” our framework can be translated from presidential to
parliamentary systems or corporatist and pluralist systems as explicated in
Hillman and Keim (1995) and Hillman (2003). Specifically, there is an
elective affinity between our model and the predictions in the literature on
presidential versus parliamentary systems. Presidential systems that are

nonmarket strategy will depend on the relative
policy preferences and formal structure of the dif-
ferent institutions (de Figueiredo & de Figueiredo,
2002; Hillman & Hitt, 1999; Holbum & Vanden
Bergh, 2008; Vanden Bergh &. Holbum, 2007).
Following the logic of Holbum and Vanden Bergh
(2008) and Vanden Bergh and Holbum (2007),
the pivotal political institution or actor is the one
that represents, in essence, the swing vote.

In a competitive political environment, the
focal firm will tend to allocate greater resources to
pivotal legislators/executives to counteract pres-
sure brought by opposing ideology-motivated op-
ponents. In a less competitive environment, ap-
pointed party leaders are pivotal, as they organize
the politicians’ preferences and constrain rivalry.
Targeting party leaders is, however, more expen-
sive than targeting legislators and the executive,
as parties have ongoing costs of operation and
costs of maintaining an organization and compet-
ing in elections (Stigler, 1971). Again, the most
uncertain or least attractive political market (Gell
NG/I) requires regulated firms to allocate signifi-
cant resources to comprehensively target multiple
political actors (Vanden Bergh &. Holbum, 2007)

explicitly political, more confrontational, and legislator focused will group
in Cell C/I, generally, whereas parliamentary systems will group in Cell
NC/E due to their executive focus, long-term cost-benefit analysis, and
more cooperative sensibility.

60 Academy of Management Perspectives August

(see Eigure 4, which outlines the costs of nonmar-
ket strategies). While costly, jointly targeting the
regulator, executive, legislators, and party leaders
can serve as insurance or a majority protection
strategy (Croseclose, 1996; Croseclose & Snyder,
1996). In extreme situations lacking competition
(e.g., strong autocracies), the swing vote is the
executive, and all resources must be directed to
the single pivotal actor.

In sum, the most expensive nonmarket strate-
gies are associated with the most uncertain polit-
ical markets. Yet without a nonmarket strategy
tailored to the level of regulatory uncertainty, a
firm will not (or cannot successfully) invest in a
new market.

Discussion
le illustrate our nonmarket framework by an-
‘alyzing several foreign entry decisions by
firms operating in the global telecommuni-

cations sector. Our goal is to highlight variation in
nonmarket strategy given different political land-
scapes. We discuss general strategies used by for-
eign investors and specifically address the market
entry strategies of firms domiciled in the United
States, Malaysia, Italy, and Luxembourg that in-
vested in the host markets of India, Thailand,
Russia, and the more risky emerging markets. At
the end of the section, we discuss where we need
to develop a better understanding of regulatory
uncertainty, and we provide managers with key
takeaways.

Foreign Entrants to Emerging-Market
Telecommunications Markets

In global contexts, firms are keen to manage reg-
ulatory uncertainty. Arguably, assessing the na-
ture of demand-side rivalry and the nature of
supply-side rivalry is most critical when entering
new geographic markets, where success depends
on navigating the new political landscape and
where exit strategies are typically more compli-
cated. To illustrate how our political markets and
regulatory uncertainty framework applies to firms
entering foreign markets, we focus on select cases
from the telecom sector. In doing so, we keep
variation associated with industry type constant,
effectively isolating the effect of political markets.

The telecom sector also makes for a strong test of
the proposed framework: Civen domestic con-
sumption and government oversight of pricing
and sector regulation, telecom markets are in-
tensely political affairs. The sector also exempli-
fies the tensions of entering foreign markets, as
telecom investments are characterized by high
capital intensity, significant asset specificity, and
economies of scale and scope (Williamson, 1985).
Our time period also covers the first decade of
internationalization, which has been determined
through previous research (Holburn &. Zelner,
2010) to be a critical and broadly applicable em-
pirical framework.

When a telecom firm evaluates new geographic
markets, it aims to predict the level of regulatory
uncertainty it will face over the life cycle of its
investment. Such uncertainty arises because the
regulator can terminate exclusive rights, license
new competitors, set new rate structures, change
license terms, or intervene in consumer disputes
or interconnection arrangements between service
providers. To predict the magnitude of the uncer-
tainty, the telecom firm anticipates the motiva-
tions of its primary opponents and assesses the
competitiveness of poli deal actors. Ideology-mo-
tivated opponents are often labor unions fighting
against job losses, nationalists opposed to foreign
ownership of strategic state assets, or local and
intemational development groups concerned with
universal service requirements. Efficiency-moti-
vated opponents tend to be consumers advocating
for better service or local and intemational pro-
liberalization groups opposed to anticompetitive
practices like monopolies or supportive of opening
the sector to foreign ownership. Because telecom
regulation is jointly supplied by the regulator and
other political actors (e.g., executive, legislators),
telecom firms can benefit from competition
among them. Where regulatory uncertainty ex-
ists—due to an ideology-motivated opponent
and/or lack of competitiveness of political ac-
tors—telecom firms can implement a nonmarket
strategy to mitigate the uncertainty or delay in-
vestment in the country if uncertainty is too great.

We use information from a subset of telecom
entry decisions that took place in 103 emerging
markets throughout the 1990s, the first decade of

2012 Kingsley, Vanden Bergh, and Bonardi 61

Figure 4
The Cost off Nonmarket Strategies

E

Ut

o

à
<

UJ

o
3
Ideology-
Motivated
Opponent(s)
Efficiency-
Motivated
Opponent(s)

Profile: Low & High $S

Coalition: Horizontal & Vertical SS

Pivots’: Regulator, Executive,
Legislators, Party Leaders SSS

“NC/I”

“NC/E”

Profile: Low $

Coalition: Vertical $

Pivots’: Regulator, Party Leaders $ $

; No Competition Among

i Poiiticat Actors

Iproff/e; High $

lcoa//f/on,- Horizontal $

IP/Vois,- Regulator, Executive,
¡Legislators $ $

j “C/i”
“C/E”

Profile: Low $
Coalition: Vertical $

Pivots: Regulator, Executive,
Legislators $

Competition Among

Poiiticai Actors

i NATURE OF SUPPLY-SiDE RIVALRY

1 *ln extremely uncompetitive |
1 contexts (e,g,, strong |
; autocracy). Pivots: Executive $ ;

internationalization in the telecom sector. Ana-
lyzing cases during this time frame provides spe-
cific insight into how firms integrate market and
nonmarket strategy under extreme information
constraints and in the process of new market
openings. In the 1990s, 65 of the 103 countries
experienced positive entry decisions by foreign
firms into the country’s telecom sector. In the
other 38 countries, either the sector did not open
to new entrants (e.g., China) or telecom firms
chose to postpone investing (e.g., Colombia in
1992, Pakistan in 1996, Slovakia in 1999).

Eoreign investors strategically assessed their en-
try options, specifically how well integrated strat-
egies might work and thus which ones to employ.
Eor instance, of the 597 individual foreign invest-
ments, 39.5% used traditional vertical coalitions
that involved foreign equity partners (49.8% of
investors), intemational banks (29.2% of inves-
tors), or joint ventures with locals or the govem-
ment (14.9% of investors); 19.1% used more
costly horizontal coalition strategies that involved
home govemments through bilateral investment
treaties (30.2% of investors), intemational orga-
nizations and multilateral institutions such as the
World Trade Organization General Agreement
on Trade in Services (11.2% of investors), or the
World Bank’s Intemational Centre for the Settle-
ment of Investment Disputes (15.9% of inves-
tors). These findings align with the World Bank’s

executive survey data discussed in our introduc-
tion, thus suggesting that these telecom data are a
reasonable candidate to illustrate the general im-
plications of our framework without sacrificing
external validity.

To further assess the applicability of our regu-
latory uncertainty framework and control for the
role of market strategy, we discuss three cases in
relatively similar market contexts: Thailand, Rus-
sia, and India in the mid-1990s (see Eigure 5). In
each of these settings, the competitiveness of po-
litical actors and the nature of opposing demand
vary, thereby illustrating the key dimensions of
our framework. Using the political constraint in-
dex as our proxy for the competitiveness among
political actors (Henisz, 2000), we see that both
Thailand (0.56 out of 1.00) and India (0.57 out of
1.00) demonstrated more political constraints and
thus more competition among politicians. Russia,
by contrast, had a materially lower score of 0.15,
suggesting that its political markets were less at-
tractive. In terms of ideological political opposi-
tion. Thai labor unions campaigned against for-
eign investment in the sector, citing loss of jobs
and depressed wages. Both Russia’s and India’s
foreign investment opportunities were opposed
predominantly by efficiency-motivated pro-liber-
alization groups who fought against the lack of
transparency and “worst” practices in the licens-
ing and privatization process.

62 Academy of Management Perspectives August

Figure 5
Indicative Empirical Cases

DC

<

E
UJ

M

à

Z

UJ

o
o
UJ
DC

H

Z
Ideology-
Motivated
Opponent(s)
Efficiency-
Motivated
Opponent(s)

Millicom,
Multiple Countries
199O’s

” N C / r

“NC/E”

Telecom Italia,
Russia
1995

No

Competition
Among

Political Actors

Samart,
Thailand

1997

“C/l”
“C/E”

US West,

India
1995

Competition
Among

Political Actors
NATURE OF SUPPLY-SIDE RIVALRY

India in the mid-1990s (Cell C/E) experienced
significant competition among elected politicians,
with preferences and control shifting often. US
West, an American Baby Bell, entered the Indian
market in 1995 by acquiring five licenses, most
notably a 10-year pilot license to set up India’s
first private telephone network for basic phone
services. The company pursued a baseline low-
profile strategy of working with the Indian regu-
lator almost exclusively. This involved informal
bidding for licenses (often ahead of public ten-
ders) in an attempt to manage opposition from
increasingly vocal pro-liberalization groups, in-
cluding key competitors such as NYNEX and Re-
liance (Pyramid Telecom, 1995a). To secure li-
censes and counter the efficiency opponents, US
West also structured a vertical coalition that in-
cluded its proposed equipment suppliers and the
Cellular Operators Association.

In Russia in 1995 (Cell NC/E) politics were
less competitive than in India, increasing uncer-
tainty for foreign telecommunications firms.
Much of the opposition to foreign investment was
from media and business communities who were
opposed to cozy sales lacking in transparency and
efficiency. Investors generally used baseline low-
proflle, vertical-coalition strategies as in India, but
their political targets were the party and not the
regulator, which was weak in the face of regime
transition and liberalization. Indeed, Telecom Ita-
lia found that investing in Russia required exten-
sive and quiet backroom negotiations with party

insiders. In the privatization of Russia’s state-
owned local telecommunications firm, Svyazin-
vest, foreign telecom investors such as Telecom
Italia were “careful not to arouse Russian sensibil-
ities by demanding ‘control'” and often portrayed
themselves “as a partner in Russia’s development,”
all the while negotiating with key political elites
and oligarchs (Pyramid Telecom, 1995b).

In Thailand (Cell C/I), the political environ-
ment was different. Despite ideological opposition
from labor and trade unions that feared job losses
as the sector liberalized and state-owned enter-
prises privatized (Pyramid Telecom, 1995a), Ma-
laysian company Samart entered the Thai cellular
market in 1997. The company strategically joined
forces with the state-owned Thai Telecom. It pur-
sued high-profile targeting of elected politicians in
the Thai government and tried to leverage a hor-
izontal coalition with the WTO, the IMF, and its
home govemment. In the wake of the 1997 Asian
financial crisis, the WTO and IMF had stepped in
to advocate for both government austerity and
liberalization. While not necessarily a natural
partner for a Malaysian operator, the WTO’s lib-
eralization deadline and IMF’s privatization de-
mand as a condition for financial aid played into
Samart’s desire to manage regulatory uncertainty
and enter the Thai market. Samart also rolled out
high-profile advertisements aimed at the Thai
public that advocated for privatization and foreign
ownership. Indeed, many telecommunications
flrms in the Thai market employed high-profile
strategies: One firm put out explicit ads discussing
how its acquisition would not change labor wages;
another aired an advertisement claiming that its
competitor’s handset was a health hazard.

One particular firm based in Luxembourg was
especially opportunistic and entrepreneurial in
emerging-market telecom deals. Millicom Inter-
national Cellular was a niche player in global
telecom investing and proved the second most
proliflc dealmaker in the 1990s. It pursued high-
risk opportunities in smaller markets with more
uncertain growth potential. By 1996, Millicom
had amassed 29 cellular licenses in 30 countries
covering 375 million people in Asia, Eastern Eu-
rope, and Africa. Most of Millicom’s investments

2012 Kingsley, Vanden Bergh, and Banardi 63

occurred (and continue to occur) in unattractive
political markets (Standard &. Poor’s, 1996).

To manage the regulatory uncertainty that
comes with ideological opponents and the lack of
competition among political actors (Cell NC/I),
Millicom negotiated “lucrative deals behind
closed doors, relying on the ability of its local
managers to navigate Byzantine regional bureau-
cracies and form lucrative partnerships with lead-
ing local business interests” and telephone author-
ities (Pyramid Telecom, 1996, p. 2). During its
issuance of senior subordinate debt, even the
rating agencies noted this nonmarket strategy:
“Millicom’s strategy is to develop mobile oper-
ations by finding a local partner with local
knowledge, expertise, and contacts to assist
with legal and regulatory issues, such as obtain-
ing licenses and organizing interconnection
agreements with other market participants”
(Standard & Poor’s, 2004, p. 3). This is funda-
mentally a low-profile vertical coalition target-
ing the regulator. But Millicom also actively
advertises its benefits to local consumers. Al-
though Millicom charges high handset and
monthly service charges, its service and cover-
age benefits the consumer base, and Millicom
publicizes this to engender greater support. Mil-
licom also engages local partners and regional
managers to assist with party and politician
relations.

Conclusions

Properly assessing a firm’s exposure to regulatoryuncertainty helps managers craft an appropri-ate integrated strategy. Our article suggests two
primary drivers of regulatory uncertainty for firms:
ideology-motivated interests opposed to the firm
and a lack of competition for power among polit-
ical actors such as executives and legislators. Be-
cause managers would like to devise the most
economical strategy to manage regulatory uncer-
tainty, we identify three dimensions of nonmarket
strategy—profile level, coalition breadth, and piv-
otal target—to distinguish how a regulated firm
allocates incremental resources beyond a basic
low-profile strategy that engages the regulator and
the firm’s vertical coalition. We argue and find
anecdotal evidence that managers use high-profile

strategies and recruit horizontal coalition partners
to manage ideological opponents. Managers also
target their strategy at the pivotal swing voter—
the regulator, the party, the legislators, or the
executive. In cases of extreme uncertainty, man-
agers pursue a multifaceted nonmarket strategy.

While we derive our two-by-two framework
from diverse, established literatures in political
science, economics, and management, this study
raises a number of questions that will need to be
addressed in subsequent work. For example, we are
somewhat agnostic about the relative effect of
changes in demand-side rivalry versus changes in
supply-side rivalry. Our matrix implies that
changes in demand-side rivalry have a greater
effect on the cost of nonmarket strategy, but why
this is remains incompletely understood. In addi-
tion, this piece has been silent about the nature of
the regulator. Previous research has shown that
appointed regulators create more attractive polit-
ical markets for firms, and that knowing the reg-
ulator’s preferences relative to elected politicians
and the regulated firm matters (Holbum &
Vanden Bergh, 2008). We plan an extension of
the current framework that conceptualizes the na-
ture of the regulator more precisely and identifies
how a change in the key characteristics of the
regulator changes the level of regulatory uncer-
tainty and firms’ nonmarket strategies. We also
aim to test the robustness of the theoretical frame-
work to different empirical settings, including
those with direct performance data.

This paper nonetheless makes important con-
tributions to firms’ understanding of integrated
strategy. First, we provide a flexible framework
that applies to a range of nonmarket settings. We
translate the political markets framework devel-
oped in more mature and formal institutional set-
tings to incorporate the emerging-market and de-
veloping-country context. In doing so, we
differentiate ourselves from the traditional U.S./
Eurocentric political markets literature and ad-
vance the theory. Specifically, we analyze the
supply-side interaction among multiple political
actors and decision makers, not just a select group
of (elected) regulators and legislators. Our char-
acterization of the supply side in our framework
can also accommodate extremely uncompetitive

64 Academy of Management Perspectives August

political markets situations, notably an autocratic
sovereign. Further, we unpack the nature of op-
posing demand by providing a new categorization
of interest groups based on motivation.

Second, much of the literature discussed in this
article recognizes the importance of adjusting po-
litical strategy as political uncertainty increases
(e.g., Dieleman & Boddewyn, 2012; Hillman,
2003). Our research complements this literature
by creating a framework that predicts when regu-
latory uncertainty is likely to be greater for a firm.
We accomplish this by focusing on how the key
demand- and supply-side characteristics interact
with each other to create regulatory uncertainty.
How this interaction leads to predictions about
the degree of uncertainty has not been explored in
the nonmarket strategy literature that analyzes
firms operating in different political contexts (e.g.,
Dieleman & Boddewyn, 2012; Hillman, 2003;
Lawrence, 2010; Luo & Peng, 1999).

Third, we empirically pair this novel nonmar-
ket analysis with one of a firm’s most critical
market strategies: market entry. In showing how
firms can assess regulatory uncertainty in the con-
text of entering new markets, we contribute to the
literature on integrated strategy and, separately,
offer an innovation to bargaining power theory.
The latter argues that an MNG entering a new
country has stronger bargaining power to the ex-
tent that it has, for instance, technology, jobs, and
political ties (Blumentritt, 2003; Blumentritt &.
Rehbein, 2008; Dieleman &. Boddewyn, 2012;
Lawrence, 2010). We build our framework from a
similar insight that firms negotiate for the supply
of public policy with host govemments, but we
simultaneously focus on the institutional con-
straints to firms’ bargaining power and the other
parties in the negotiation network in addition to
the host government. We also provide clarifica-
tion on when and how certain firm resources, such
as political ties, matter and affect firms’ market
strategies.

Thus we are able to complement existing in-
sights (e.g., Blumentritt, 2003) by explaining why
and when we see MNGs employing different in-
tegrated strategies as they enter different political
markets. While this insight can be viewed as con-
sistent with existing literature (e.g., Hillman,

2003), we also extend these insights by being able
to explain why different firms, operating within
the same country, employ different integrated
strategies. The key characteristics of demanders
and/or suppliers, within a given political jurisdic-
tion, can vary across firms. Finally, our insights
extend beyond market entry and can be applied
to other market strategies, such as market
consolidation.

Taken together, our nonmarket framework pro-
vides managers with clear insights on regulatory
uncertainty: Uncertainty is higher in political
markets characterized by ideologically motivated
opponents and less competition among suppliers
of policy. From this assessment, we equip manag-
ers with three discrete nonmarket strategy choices
to execute alongside market entry or other market
strategies. Synthesizing profile level, coalition
depth, and pivotal actor, we advance previously
distinct strategy arguments. Thus our insights
from regulatory uncertainty yield meaningful im-
plications for firms’ integrated strategy and thus
performance.

Acknowledgments

The authors would like to acknowledge helpful comments
received from the editor and two anonymous reviewers on
earlier versions of this article and from participants at the
2011 Strategic Management Society and 2012 Academy of
Intemational Business annual meetings.

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Appendix 1

World Bonk (2011) Executives Survey

The survey was conducted on behalf of the World Bank’s
Multilateral Investment Guarantee Agency by the Econo-
mist Intelligence Unit. It contains the responses of 316
senior executives (146 chief-level) at multinational enter-
prises investing in developing countries. The geographic
distribution of the respondents is Asia 62, North America
87, Europe 135, and the rest of world 32. The survey in-
cludes 186 organizations with revenue over $500 million in
the following industries (number of executives in parenthe-
ses): primary (26), manufacturing (80), services (110), fi-
nance (77), utilities/transportation/storage/communications
(23). Quota sampling was used to ensure that the industry
and geographic composition of the survey sample approxi-
mated the composition of actual foreign direct investment
outflows to developing countries. We used the following
survey questions in this paper.

Question lOo. In your opinion, which types of political risk are
of most concem to your company when investing in emerg-
ing markets? Select up to three. Transfer and convertibility
restrictions, breach of contract, non-honoring of govem-
ment guarantees, expropriation/nationalization, adverse reg-
ulatory changes, war, terrorism, civil disturbance.

Question 11. In your opinion, in the developing countries
where your firm invests presently, how do each of the risks
listed below affect your company? Rate each risk on a scale
of 1-5 where 1 = Very high impact and 5 = No impact.
Transfer and convertibility restrictions, breach of contract,
non-honoring of govemment guarantees, expropriation/na-
tionalization, adverse regulatory changes, war, terrorism,
civil disturbance.

2012 Kingsley, Vanden Bergh, and Bonardi 67

Question 12. In the past 3 years has your company experienced
financial losses due to any of the following risks? Select all
that apply. Transfer and convertibility restrictions, breach of
contract, non-honoring of govemment guarantees, expro-
priation/nationalization, adverse regulatory changes, war,
terrorism, civil disturbance.

Question 13. To your knowledge, have any of the following
risks caused your company to withdraw an existing invest-
ment or cancel planned investments over the past
12 months? Select one answer for each risk (see question
12). Withdraw existing investment, cancel planned invest-

ments, both withdraw and cancel, neither withdraw nor
cancel, don’t know.

Question 15. In your opinion, in the countries where your
company invests, what are the most effective tools/mech-
anisms available to your firm for alleviating each of the
following risks? Select one tool for each risk (see question
12). Engage with local public entities, joint venture with
local enterprises, risk analysis/monitor, relationships with
key political leaders, political risk insurance, risk insig-
nificant for projects, no existing tool can alleviate
this risk.

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Instructor’s Resource Manual

For
Multinational Business Finance
Fourteenth Edition

David K. Eiteman
University of California, Los Angeles

Arthur I. Stonehill
Oregon State University and University of Hawaii at Manoa

Michael H. Moffett
Thunderbird School of Global Management
at Arizona State University

Copyright 2016 Pearson Education, Inc.

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Copyright © 2016, 2013, 2010 Pearson Education, Inc., or its affiliates. All Rights Reserved.
Manufactured in the United States of America. This publication is protected by copyright, and permission
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ISBN-13: 978-0-13-387987-2
ISBN-10: 0-13-387987-9

©2016 Pearson Education, Inc.
Contents
Chapter 1 Multinational Financial Management: Opportunities and Challenges …………………….. 1
Chapter 2 The International Monetary System …………………………………………………………………… 7
Chapter 3 The Balance of Payments ……………………………………………………………………………….. 12
Chapter 4 Financial Goals and Corporate Governance ………………………………………………………. 20
Chapter 5 The Foreign Exchange Market ………………………………………………………………………… 25
Chapter 6 International Parity Conditions ……………………………………………………………………….. 31
Chapter 7 Foreign Currency Derivatives: Futures and Options …………………………………………… 38
Chapter 8 Interest Rate Risk and Swaps ………………………………………………………………………….. 43
Chapter 9 Foreign Exchange Rate Determination …………………………………………………………….. 48
Chapter 10 Transaction Exposure …………………………………………………………………………………… 55
Chapter 11 Translation Exposure ……………………………………………………………………………………. 60
Chapter 12 Operating Exposure ………………………………………………………………………………………. 64
Chapter 13 The Global Cost and Availability of Capital ……………………………………………………. 68
Chapter 14 Raising Equity and Debt Globally ………………………………………………………………….. 72
Chapter 15 Multinational Tax Management …………………………………………………………………….. 79
Chapter 16 International Trade Finance …………………………………………………………………………… 85
Chapter 17 Foreign Direct Investment and Political Risk ………………………………………………….. 89
Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions ……………………… 101

© 2016 Pearson Education, Inc.
CHAPTER 1
MULTINATIONAL FINANCIAL MANAGEMENT:
OPPORTUNITIES AND CHALLENGES

1. Globalization Risks in Business. What are some of the risks that come with the growing
globalization of business?

Exchange rates. The international monetary system, an eclectic mix of floating and managed
fixed exchange rates, is constantly changing. For example, the growth of the Chinese yuan is now
changing the global currency landscape.

Interest rates. Large fiscal deficits, including the current eurozone crisis, plague most of the major
trading countries of the world, complicating fiscal and monetary policies, and ultimately, interest
rates and exchange rates.

Many countries experience continuing balance of payments imbalances, and in some cases,
dangerously large deficits and surpluses, all will inevitably move exchange rates.

Ownership, control, and governance vary radically across the world. The publicly traded
company is not the dominant global business organization—the privately held or family-owned
business is the prevalent structure—and their goals and measures of performance vary
dramatically.

Global capital markets that normally provide the means to lower a firm’s cost of capital, and even
more critically, increase the availability of capital, have in many ways shrunk in size and have
become less open and accessible to many of the world’s organizations.

Financial globalization has resulted in the ebb and flow of capital in and out of both industrial and
emerging markets, greatly complicating financial management (Chapters 5 and 8).

2. Globalization and the MNE. The term globalization has become widely used in recent years. How
would you define it?

Narayana Murthy’s quote is a good place to start any discussion of globalization:

“I define globalization as producing where it is most cost-effective, selling where it is most
profitable, and sourcing capital where it is cheapest, without worrying about national
boundaries.”
Narayana Murthy, President and CEO, Infosys

3. Assets, Institutions, and Linkages. Which assets play the most critical role in linking the major
institutions that make up the global financial marketplace?

The debt securities issued by governments. These low risk or risk-free assets form the foundation for
the creation, trading, and pricing of other financial assets like bank loans, corporate bonds, and
equities (stock). In recent years, a number of additional securities have been created from the existing

2 Eiteman/Stonehill/Moffett | Multinational Business Finance, 14th Edition

© 2016 Pearson Education, Inc.
securities—derivatives, whose value is based on market value changes in the underlying securities.
The health and security of the global financial system relies on the quality of these assets.

4. Currencies and Symbols. What technological change is even changing the symbols we use in the
representation of different country currencies?

As currency trading has shifted from verbal telephone conversations to electronic and digital trading,
currency symbols (many of which were not common across alphabetic platforms, like the British
pound, £) have been replaced with the ISO-4217 codes, three-letter currency codes like USD, EUR,
and GBP.

5. Eurocurrencies and LIBOR. Why have eurocurrencies and LIBOR remained the centerpiece of the
global financial marketplace for so long?

Eurocurrencies and LIBOR (and there are LIBOR rates for all eurocurrencies) reflect the “purest” of
market-driven currencies and instrument rates. They are largely unregulated and, therefore, reflect
freely traded assets whose value is set by the daily global marketplace.

6. Theory of Comparative Advantage. Define and explain the theory of comparative advantage.

The theory of comparative advantage provides a basis for explaining and justifying international trade
in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless
information, and no government interference. The theory contains the following features:

Exporters in Country A sell goods or services to unrelated importers in Country B.

Firms in Country A specialize in making products that can be produced relatively efficiently,
given Country A’s endowment of factors of production: that is, land, labor, capital, and
technology. Firms in Country B do likewise, given the factors of production found in Country B.
In this way, the total combined output of A and B is maximized.

Because the factors of production cannot be moved freely from Country A to Country B, the
benefits of specialization are realized through international trade.

The way the benefits of the extra production are shared depends on the terms of trade, the ratio at
which quantities of the physical goods are traded. Each country’s share is determined by supply
and demand in perfectly competitive markets in the two countries. Neither Country A nor
Country B is worse off than before trade, and typically both are better off, albeit perhaps
unequally.

7. Limitations of Comparative Advantage. Key to understanding most theories is what they say and
what they don’t. Name four or five key limitations to the theory of comparative advantage.

Although international trade might have approached the comparative advantage model during the
nineteenth century, it certainly does not today, for the following reasons:

Countries do not appear to specialize only in those products that could be most efficiently
produced by that country’s particular factors of production. Instead, governments interfere with
comparative advantage for a variety of economic and political reasons, such as to achieve full
employment, economic development, national self-sufficiency in defense-related industries, and

Chapter 1 Multinational Financial Management: Opportunities and Challenges 3

© 2016 Pearson Education, Inc.
protection of an agricultural sector’s way of life. Government interference takes the form of
tariffs, quotas, and other non-tariff restrictions.

At least two of the factors of production, capital and technology, now flow directly and easily
between countries, rather than only indirectly through traded goods and services. This direct flow
occurs between related subsidiaries and affiliates of multinational firms, as well as between
unrelated firms via loans and license and management contracts. Even labor flows between
countries, such as immigrants into the United States (legal and illegal), immigrants within the
European Union and other unions.

Modern factors of production are more numerous than in this simple model. Factors considered in
the location of production facilities worldwide include local and managerial skills, a dependable
legal structure for settling contract disputes, research and development competence, educational
levels of available workers, energy resources, consumer demand for brand name goods, mineral
and raw material availability, access to capital, tax differentials, supporting infrastructure (roads,
ports, communication facilities), and possibly others.

Although the terms of trade are ultimately determined by supply and demand, the process by
which the terms are set is different from that visualized in traditional trade theory. They are
determined partly by administered pricing in oligopolistic markets.

Comparative advantage shifts over time as less developed countries become more developed and
realize their latent opportunities. For example, during the past 150 years, comparative advantage
in producing cotton textiles has shifted from the United Kingdom to the United States to Japan to
Hong Kong to Taiwan and to China.

The classical model of comparative advantage did not really address certain other issues, such as
the effect of uncertainty and information costs, the role of differentiated products in imperfectly
competitive markets, and economies of scale.

Nevertheless, although the world is a long way from the classical trade model, the general principle of
comparative advantage is still valid. The closer the world gets to true international specialization, the
more world production and consumption can be increased, provided the problem of equitable
distribution of the benefits can be solved to the satisfaction of consumers, producers, and political
leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect
competition is a limiting case in microeconomic theory.

8. International Financial Management. What is different about international financial management?

Multinational financial management requires an understanding of cultural, historical, and institutional
differences, such as those affecting corporate governance. Although both domestic firms and MNEs
are exposed to foreign exchange risks, MNEs alone face certain unique risks, such as political risks,
that are not normally a threat to domestic operations.

MNEs also face other risks that can be classified as extensions of domestic finance theory. For
example, the normal domestic approach to the cost of capital, sourcing debt and equity, capital
budgeting, working capital management, taxation, and credit analysis needs to be modified to
accommodate foreign complexities. Moreover, a number of financial instruments that are used in
domestic financial management have been modified for use in international financial management.
Examples are foreign currency options and futures, interest rate and currency swaps, and letters of
credit.

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9. Ganado’s Globalization. After reading the chapter’s description of Ganado’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 in the following two paragraphs.

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 or supplying
parts from one country operation to another.

Global is a newer term that essentially means about the same as “multinational,” i.e., operating
around the globe. Global has tended to replace other terms because of its use by 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.”

10. Ganado, the MNE. At what point in the globalization process did Ganado become a multinational
enterprise (MNE)?

Ganado 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.

11. Role of Market Imperfections. What is the role of market imperfections in the creation of
opportunities for the multinational firm?

MNEs strive to take advantage of imperfections in national markets for products, factors of
production, and financial assets.

Imperfections in the market for products translate into market opportunities for MNEs. Large
international firms are better able to exploit such competitive factors as economies of scale,
managerial and technological expertise, product differentiation, and financial strength than their
local competitors are.

MNEs thrive best in markets characterized by international oligopolistic competition, where these
factors are particularly critical.

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Once MNEs have established a physical presence abroad, they are in a better position than purely
domestic firms are to identify and implement market opportunities through their own internal
information network.

12. Why Go. What do firms become multinational?

1. 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
2. Acquisition of raw materials, not available elsewhere
3. Achievement of greater efficiency, by producing in countries where one or more of the factors of
production are underpriced relative to other locations
4. Acquisition of knowledge and expertise centered primarily in the foreign location
5. Location of the firms’ foreign operations in countries deemed politically safe

13. Multinational Versus International. What is the difference between an international firm and a
multinational firm?

A multinational firm goes beyond simply selling to or trading with firms in foreign countries
(international), by expanding its intellectual capital and acquiring a physical presence in foreign
countries. This allows the firm to expand and deepen its core competitiveness and global reach to
more markets, customers, suppliers, and partners.

14. Ganado’s Phases. What are the main phases that Ganado 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 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

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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.

15. Financial Globalization. How do the motivations of individuals, both inside and outside the
organization or business, define the limits of financial globalization?

If influential insiders in corporations and sovereign states continue to pursue the increase in firm
value, there will be a definite and continuing growth in financial globalization. But if these same
influential insiders pursue their own personal agendas, which may increase their personal power,
influence, or wealth, then capital will not flow into these sovereign states and corporations. The result
is the growth of financial inefficiency and the segmentation of globalization outcomes creating
winners and losers.

The three fundamental elements—financial theory, global business, management beliefs and
actions—combine to present either the problem or the solution to the growing debate over the benefits
of globalization to countries and cultures worldwide.

© 2016 Pearson Education, Inc.
CHAPTER 2
THE INTERNATIONAL MONETARY SYSTEM

1. The Rules of the Game. Under the gold standard, all national governments promised to follow the
“rules of the game.” What did this mean?

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.

2. Defending a Fixed Exchange Rate. What did it mean under the gold standard to “defend a fixed
exchange rate,” and what did this imply about a country’s money supply?

Under the gold standard, a country’s central bank was responsible for preserving the exchange value
of the country’s currency by being willing and able to exchange its currency for gold reserves upon
the demand by a foreign central bank. This required the country to restrict the rate of growth in its
money supply to a rate that would prevent inflationary forces from undermining the country’s own
currency value.

3. Bretton Woods. What was the foundation of the Bretton Woods international monetary system, and
why did it eventually fail?

Bretton Woods, the fixed exchange rate regime of 1945–73, 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 and 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 it was no longer
able to guarantee conversion of dollars into its diminishing store of gold.

4. Technical Float. What specifically does a floating rate of exchange mean? What is the role of
government?

A truly floating currency value means that the government does not set the currency’s value or
intervene in the marketplace, allowing the supply and demand of the market for its currency to
determine the exchange value.

5. Fixed versus Flexible. 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

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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.

6. De facto and de jure. What do the terms de facto and de jure mean in reference to the International
Monetary Fund’s use of the terms?

A country’s actual exchange rate practices is the de facto system. This may or may not be what the
“official” or publicly and officially system commitment, the de jure system.

7. Crawling Peg. How does a crawling peg fundamentally differ from a pegged exchange rate?

In a crawling peg system, the government will make occasional small adjustments in its fixed rate of
exchange in response to changes in a variety of quantitative indicators, such as inflation rates or
economic growth. In a truly pegged exchange rate regime, no such changes or adjustments are made
to the official fixed rate of exchange.

8. Global Eclectic. What does it mean to say the international monetary system today is a global
eclectic?

The current global market in currency is dominated by two major currencies, the U.S. dollar and the
European euro, and after that, a multitude of systems, arrangements, currency areas, and zones.

9. The Impossible Trinity. Explain what is meant by the term impossible trinity and why it is in fact
“impossible.”

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.

10. The Euro. Why is the formation and use of the euro considered to be of such a great
accomplishment? Was it really needed? Has it been successful?

The creation of the euro required a near-Herculean effort to merge the monetary institutions of
separate sovereign states. This required highly disparate cultures and countries to agree to combine,

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giving up a large part of what defines an independent state. Member states were so highly integrated
in terms of trade and commerce that maintaining separate currencies and monetary policies was an
increasing burden on both business and consumers, adding cost and complexity, which added sizable
burdens to global competitiveness. The euro is widely considered to have been extremely successful
since its launch.

11. Currency Board or Dollarization. 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.

12. Argentine Currency Board. 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:

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.

This problem was aggravated by the devaluation of the Brazilian real in the late 1990s.

These two problems, in turn, led to continued trade deficits and a loss of foreign exchange
reserves by the Argentine central bank.

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.

13. Special Drawing Rights. What are 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 that have 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.

14. The Ideal Currency. 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:

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1. Exchange rate stability. The value of the currency would be fixed in relationship to other major
currencies so that 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; thus, 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.

The reason that it is termed the Impossible Trinity is that a country must give up one of the three goals
described by the sides of the triangle, monetary independence, exchange rate stability, or full financial
integration. The forces of economics do not allow the simultaneous achievement of all three.

15. Emerging Market Regimes. 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?

Highly restrictive regimes like currency boards and dollarization require a country to give up the
majority of its discretionary ability over its own currency’s value. Currency boards, like that used by
Argentina in the 1990s, restricted the rate of growth in the country’s monetary policy in order to
preserve a fixed exchange rate regime. This proved to be a very high price for Argentine society to
pay and, in the end, could not be maintained. Dollarization, an even more radical extreme in the
adoption of another country’s currency for all exchange, removes one of a government’s major
attributes of sovereignty.

A free-floating rate of exchange is, however, in many ways not that different from the highly
restrictive choices just mentioned. In a free-floating regime, the government allows the foreign
currency markets to determine the currency’s value, although the government does maintain
sovereignty over its own monetary policy, which in turn has significant direct impacts on the
currency’s value.

16. Globalizing the Yuan. What are the major changes and developments that must occur for the
Chinese yuan to be considered “globalized”?

First, the yuan must become readily accessible for trade transaction purposes. This is the fundamental
and historical use of currency. Secondly, it then needs to mature toward a currency easily and openly
useable for international investment purposes. The third and final stage of currency globalization is
when the currency itself takes on a role as a reserve currency, currency held by central banks of other
countries as a store of value and a medium of exchange for their own currencies.

17. Triffin Dilemma. What is the Triffin Dilemma? How does it apply to the development of the Chinese
yuan as a true global currency?

The Triffin Dilemma is the potential conflict in objectives that may arise between domestic monetary
and currency policy objectives and external or international policy objectives when a country’s
currency is used as a reserve currency. Domestic monetary and economic policies may on occasion
require both contraction and the creation of a current account surplus (balance on trade surplus).

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18. China and the Impossible Trinity. What choices do you believe that China will make in terms of
the Impossible Trinity as it continues to develop global trading and use of the Chinese yuan?

This is purely speculative opinion, but many believe China will continue to move the yuan toward
globalization rapidly. As Chinese financial institutions and policies become more mature, and policies
more consistent with those of other major country financial markets, the yuan will grow as a medium
of exchange for both commercial trade and capital investment transactions. The gradual opening of
the Chinese economy to foreign investment is a critical component of this process.

© 2016 Pearson Education, Inc.
CHAPTER 3
THE BALANCE OF PAYMENTS

1. Balance of Payments Defined. What is the balance of payments?

The measurement of all international economic transactions between the residents of a country and
foreign residents is called the balance of payments (BOP).

2. BOP Data. 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.

3. Importance of BOP. 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.

4. Flow Statement. What does it mean to describe the balance of payments as a flow statement?

The BOP is often misunderstood because many people infer from its name that it is a balance sheet,
whereas in fact it is a cash flow statement. By recording all international transactions over a period
such as a year, the BOP tracks the continuing flows of purchases and payments between a country
and all other countries. It does not add up the value of all assets and liabilities of a country on a
specific date like a balance sheet does for an individual firm.

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

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

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.

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6. Balance. 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 are collected on a single entry basis and some data are missed, the equalization
usually does not occur. The imbalance is plugged by an entry called “errors and omissions” that
makes the accounts balance.

7. BOP Accounting. 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 flow statement in that the balance
of payments records events that cause the receipt (earnings) and disbursement (expenditures) into and
out of the country.

8. Current Account. 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.

9. Real versus Financial Assets. 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.

10. Direct versus Portfolio Investments. 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

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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.

11. Net International Investment Position. What is a country’s net international investment position,
and how does it differ from the balance of payments?

The net international investment position (NIIP) of a country is an annual measure of the assets
owned abroad by its citizens, its companies, and its government, less the assets owned by foreigners
public and private in their country. Whereas a country’s balance of payments is often described as a
country’s international cash flow statement, the NIIP may be interpreted as the country’s
international balance sheet. NIIP is a country’s stock of foreign assets minus its stock of foreign
liabilities.

12. The Financial Account. What are the primary sub-components of the financial account?
Analytically, what would cause net deficits or surpluses in these individual components?

The main components and possible examples follow:

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 U.S. treasury bills to hold as part of its foreign exchange
reserves.

Net financial derivatives
Debit: A U.S. firm purchases a financial derivative, like a currency swap, in London
Credit: A U.S. firm sells a financial derivative, like a forward contract on the dollar versus the
pound, to a London buyer

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.

13. Classifying Transactions. 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.

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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 United States 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 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.

g. 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.

h. 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.

i. 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.

j. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can fly the return
segment of a flight 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.

k. 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.

l. The U.S. army buys food for its troops in South Asia from vendors 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.

m. 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.

n. 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.

o. 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
Colombian current accounts. Assuming the cash was “laundered” appropriately, from the point of

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view of the smugglers, bank accounts in the United States 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.

p. 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.

q. 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 United States
and the Suez Canal Authority of Egypt redeposited the proceeds in the United States, 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.

r. A German automobile firm pays the salary of its 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.

s. 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.

t. 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 United
States, that would be recorded in the income part of the current accounts.

u. 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.

14. The Balance. What are the main summary statements of the balance of payments accounts, and what
do they measure?

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

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

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

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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.

15. Twin Surpluses. Why is China’s twin surpluses—a surplus in both the current and financial
accounts—considered unusual?

China’s surpluses in both the current and financial accounts—termed the twin surplus in the business
press—is highly unusual. Ordinarily, countries experiencing large current account deficits fund these
deficits through equally large surpluses in the financial account, and vice versa.

China has experienced a massive current account surplus and a sometimes sizable financial account
surplus simultaneously. This is rare and an indicator of just how exceptional the growth of the
Chinese economy has been. Although current account surpluses of this magnitude would ordinarily
create a financial account deficit, the positive prospects of the Chinese economy have drawn such
massive capital inflows into China in recent years that the financial account too is in surplus.

16. Capital Mobility—United States. The U.S. 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 during 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.

17. Capital Mobility—Brazil. 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 hyperinflation.

18. BOP Transactions. 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 is air crews.
Current account: Goods: Imports
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.
Unrecorded but should be a current account item.

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

19. BOP and Exchange Rates. What is the relationship between the balance of payments and a fixed or
floating exchange rate regime?

Fixed Exchange Rate System. Under a fixed exchange rate system, the government bears the
responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts do
not approximate zero, the government is expected to intervene in the foreign exchange market by
buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater
than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed
exchange rate, the government must then intervene in the foreign exchange market and sell domestic
currency for foreign currencies or gold in order to bring the BOP back to near zero.

Floating Exchange Rate System. Under a floating exchange rate system, the government of a
country has no responsibility to peg its foreign exchange rate. The fact that the current and capital
account balances do not sum to zero will automatically—in theory—alter the exchange rate in the
direction necessary to obtain a BOP near zero. For example, a country running a sizable current
account deficit and a capital and financial accounts balance of zero will have a net BOP deficit. An
excess supply of the domestic currency will appear on world markets. Like all goods in excess
supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency
will fall in value, and the BOP will move back toward zero.

20. J-Curve Dynamics. What is the J-Curve adjustment path?

A country’s trade balance may change as a result of an exchange rate change in the shape of a
flattened “j.” International economic analysis characterizes the trade balance adjustment process as
occurring in three stages: (1) the currency contract period, (2) the pass-through period, and (3) the
quantity adjustment period. Assuming that the trade balance is already in deficit prior to the
devaluation, a devaluation may actually result in the trade balance first worsening before improving
as a result of the three distinct commercial periods.

21. Evolution of Capital Mobility. Has capital mobility improved steadily over the past 50 years?

The magnitude of capital movements globally has increased dramatically during the past 50 years.
Capital inflows and outflows for major industrial countries now dwarf the transaction values of
current account activities. These massive capital movements, if allowed to move without restriction,
may cause increasing instability in economies, however, like that of Iceland in recent years. So to ask
if “capital mobility has improved” is a bit of tricky question; capital mobility has definitely increased,
if that is what is meant by “improved.”

22. Restrictions on Capital Mobility. What factors seem to play a role in a government’s choice to
restrict capital mobility?

There is a spectrum of motivations for capital controls, with most associated with either insulating the
domestic monetary and financial economy from outside markets or political motivations over
ownership and access interests. Capital controls are just as likely to occur over capital inflows as they
are over capital outflows. Although there is a tendency for a negative connotation to accompany
capital controls (possibly the bias of the word “control” itself), the impossible trinity requires that
capital flows be controlled if a country wishes to maintain a fixed exchange rate and an independent
monetary policy.

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23. Capital Controls. Which do most countries control, capital inflows or capital outflows? Why?

Although the fear of major government policy makers is often the flight of capital, capital outflows,
massive capital inflows are often considered potentially more disruptive if not managed correctly. As
a result, most countries are slow and careful to deregulate capital inflows, allowing them more control
over what kinds of capital over what periods of time enter the country. If regulated on entry, they are
typically easier to regulate on exit.

24. Globalization and Capital Mobility. How does capital mobility typically differ between
industrialized countries and emerging market countries?

Emerging market countries, by definition, have relatively small and undeveloped financial systems
and sectors. Outside of some potential foreign direct investment opportunities, they offer few choices
for capital to flow in of substance. Industrialized countries, however, typically have large and
sophisticated financial sectors that offer a multitude of financial investment options and assets, which
on occasion may attract large capital inflows (and in other periods, may suffer large capital outflows).

© 2016 Pearson Education, Inc.
CHAPTER 4
FINANCIAL GOALS AND CORPORATE GOVERNANCE

1. Business Ownership. What are the predominant ownership forms in global business?

Business ownership can first be divided between state ownership and private ownership. State
ownership, public ownership, is probably the largest globally. Private ownership, where a business is
owned by an individual, partners, a family, or a collection of private investors, is business that is
owned generally for more singular purposes like profit.

2. Business Control. How does ownership alter the control of a business organization? Is the control of
a private firm that different from a publicly traded company?

Privately controlled companies—a single individual or family—is often characterized by top-down
control, where the owner is active in more of the daily strategic and operational decisions made in the
firm. The publicly traded firm, where management acts as an agent of the owner, often has more
decentralized decision making and may use more consensus based direction.

3. Separation of Ownership and Management. Why is this separation so critical to the understanding
of how businesses are structured and led?

The field of agency theory is the study of how shareholders can motivate management to accept the
prescriptions of the Shareholder Wealth Maximization (SWM) model. For example, liberal use of
stock options should encourage management to think like shareholders. Whether these inducements
succeed is open to debate. However, if management deviates too much from SWM objectives of
working to maximize the returns to the shareholders, the board of directors should replace them. In
cases where the board is too weak or ingrown to take this action, the discipline of the equity markets
could do it through a takeover. This discipline is made possible by the one-share, one-vote rule that
exists in most Anglo-American markets.

4. Corporate Goals: Shareholder Wealth Maximization. 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.

5. Corporate Goals: Stakeholder Capitalism Maximization (SCM). Explain the assumptions and
objectives of the stakeholder capitalization 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

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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.

6. Management’s Time Horizon. Do shareholder wealth maximization and stakeholder capitalism have
the same time-horizon for the strategic, managerial, and financial objectives of the firm? How do they
differ?

Companies pursuing shareholder returns, particularly publicly traded firms, have a very short time
horizon for financial results. The 90-day time interval, the quarterly result, is a very short period for
companies to continually demonstrate the success or failure of corporate strategy and operational
execution. Stakeholder capitalist firms, firms pursuing a complex combination of goals and services
for a variety of stakeholders, may have a consistently longer time horizon.

7. Operational Goals. 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. In other
words, 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.

8. Financial Returns. How do shareholders in a publicly traded firm actually reap cash flow returns
from their ownership? Who has control over which of these returns?

The return to a shareholder in a publicly traded firm combines current income in the form of
dividends and capital gains from the appreciation of share price:

2 2 1
1 1
ShareholderReturn
−
= +
D P P
P P

where the initial price, P1, is equivalent to the initial investment by the shareholder, and P2 is the price
of the share at the end of period. The shareholder theoretically receives income from both
components. For example, duirng the past 60 years in the U.S. marketplace, a diversified investor
may have received a total average annual return of 14%, split roughly between dividends, 2%, and
capital gains, 12%.

Management generally believes it has the most direct influence over the first component, the dividend
yield. Management makes strategic and operational decisions, which grow sales and generate profits,

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and then distributes those profits to ownership in the form of dividends. Capital gains, the change in
the share price as traded in the equity markets, is much more complex and reflects many forces that
are not in the direct control of management. Despite growing market share, profits, or any other
traditional measure of business success, the market may not reward these actions directly with share
price appreciation.

A privately held firm has a much simpler shareholder return objective function: maximize current and
sustainable income. The privately held firm does not have a share price (it does have a value, but this
is not a definitive market-determined value in the way in which we believe markets work). It
therefore simply focuses on generating current income, dividend income, to generate the returns to its
ownership. If the privately held ownership is a family, the family may also place a great emphasis on
the ability to sustain those earnings over time while maintaining a slower rate of growth that can be
managed by the family itself.

9. Dividend Returns. Are dividends really all that important to investors in publicly traded companies?
Aren’t capital gains really the point or objective of the investor?

Although on average over the past century in the U.S. capital markets capital gains are larger than
dividend income, dividend income is considered much more stable and more reliable than capital
gains. As a result, different investors view dividends versus capital gains differently. Investors
looking for regular current period income may be attracted to high dividend yielding equities.

10. Ownership Hybrids. What is a hybrid? How may it be managed differently?

Many firms around the world are both publicly traded but privately controlled. This is typical of
family-owned businesses that have gone public but the family retains controlling interest in the firm.
Because private/family ownership generally has a longer time horizon than publicly traded firms,
these firms may behave more like private firms, being more “patient” in terms of seeing the financial
and operational results of corporate investment and strategy.

11. Corporate Governance. Define corporate governance and the various stakeholders involved in
corporate governance. What is the difference between internal and external 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 decisions 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 that own shares of stock and that elected the board of
directors.

The governance of all firms is a combination of internal and external. Internal governance comes
from the corporate board and the senior executive management team. External governance is
exercised by all external stakeholders of the firm—the equity markets, debt markets, exchanges,
regulatory bodies of all kinds, auditors, and legal service providers.

12. Governance Regimes. What are the four major types of governance regimes and how do they differ?

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The four major corporate governance regimes are (1) market-based, characterized by dispersed
ownership and a separation of ownership from management; (2) family-based, where ownership and
management are often combined; (3) bank-based, where government frequently controls bank lending
practices, restricting the growth rate of industry, and sometimes combined control between family and
government; and (4) government affiliated, where government exclusively directs business activity
with little minority interest or influence. Exhibit 4.6 details the four regimes as well as providing a
sampling of representative countries characterized by these regimes.

13. Governance Development Drivers. What are the primary drivers of corporate governance across the
globe? Is the relative weight or importance of some drivers increasing over others?

Changes in corporate governance principles and practices globally have had four major drivers: (1)
the financial market development; (2) the degree of separation between management and ownership;
(3) the concept of disclosure and transparency; and (4) the historical development of the legal system.

14. Good Governance Value. Does good governance have a “value” in the marketplace? Do investors
really reward good governance, or does good governance just attract a specific segment of investors?

This is basically a rhetorical question for student discussion. There have been a number of studies, for
example by McKinsey, as to what premium—if any—that institutional investors would be willing to
pay for companies with good governance within specific country-markets. The results indicate in
certain circumstances the market may be willing to pay a small premium, but in general, the results to
date have been unconvincing.

15. Shareholder Dissatisfaction. What alternative actions can shareholders take if they are dissatisfied
with their company?

Disgruntled shareholders may do the following:

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

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much more difficult, in part because nonshareholder stakeholder wishes are considered in any
board action. (One can argue as to whether the long-run interests of nonshareholding 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.

16. Emerging Markets Corporate Governance Failures. 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.

17. Emerging Markets Corporate Governance Improvements. 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 growth. Country markets that have had relatively slow growth or have industrialized rapidly
utilizing neighboring capital markets, 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.

© 2016 Pearson Education, Inc.
CHAPTER 5
THE FOREIGN EXCHANGE MARKET

1. Definitions. Define the following terms:

a. Foreign exchange market. The foreign exchange market provides the physical and institutional
structure through which the money of one country is exchanged for that of another country, the
rate of exchange between currencies is determined, and foreign exchange transactions are
physically completed .

b. Foreign exchange transaction. A foreign exchange transaction is an agreement between a buyer
and seller that a fixed amount of one currency will be delivered for some other currency at a
specified rate.

c. Foreign exchange. Foreign exchange means the money of a foreign country; that is, foreign
currency bank balances, bank notes, checks, and drafts.

2. Functions of the Foreign Exchange Market. What are the three major functions of the foreign
exchange market?

To transfer purchasing power from one country and its currency to another. Typical parties would
be importers and exporters, investors in foreign securities, and tourists.

To finance goods in transit. Typical parties would be importers and exporters.

To provide hedging facilities. Typical parties would be importers, exporters, and creditors and
debtors with short-term monetary obligations.

3. Structure of the FX Market. How is the global foreign exchange market structured? Is digital
telecommunications replacing people?

One of the biggest changes in the foreign exchange market in the past decade has been its shift from a
two-tier market (the interbank or wholesale market and the client or retail market) to a single-tier
market. Electronic platforms and the development of sophisticated trading algorithms have facilitated
market access by traders of all kinds and sizes.

Participants in the foreign exchange market can be simplistically divided into two major groups: those
trading currency for commercial purposes, liquidity seekers, and those trading for profit, profit
seekers. Although the foreign exchange market began as a market for liquidity purposes, facilitating
the exchange of currency for the conduct of commercial trade and investment purposes, the
exceptional growth in the market has been largely based on the expansion of profit-seeking agents. As
might be expected, the profit seekers are typically much better informed about the market, looking to
profit from its future movements, while liquidity seekers simply wish to secure currency for
transactions. As a result, the profit seekers generally profit from the liquidity seekers.

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4. Market Participants. For each of the foreign exchange market participants, identify their motive for
buying or selling foreign exchange.

Foreign exchange dealers are banks and a few nonbank institutions that “make a market” in
foreign exchange. They buy and sell foreign exchange in the wholesale market and resell or rebuy
it from customers at a slight change from the wholesale price.

Foreign exchange brokers (not to be confused with dealers) act as intermediaries in bringing
dealers together, either because the dealers do not want their identity revealed until after the
transaction or because the dealers find that brokers and “shop the market,” i.e., scan the bid and
offer prices of many dealers very quickly.

Individuals and firms conducting international business consist primarily of three categories:
importers and exporters, companies making direct foreign investments, and securities investors
buying or selling debt or equity investments for their portfolios.

Speculators and arbitragers buy and sell foreign exchange for profit. Speculators and arbitragers
buy or sell foreign exchange on the basis of which direction they believe a currency’s value will
change in the immediate or speculative horizon.

Central banks and treasuries buy and sell foreign exchange for several purposes, but most
importantly, for intervention in the marketplace. Direct intervention, in which the central bank
will buy (sell) its own currency in the market with its foreign exchange reserves to push its value
up (down), is a very common activity by government treasuries and central banking authorities.

5. Foreign Exchange Transaction. Define each of the following types of foreign exchange
transactions:

a. Spot. A spot transaction is an agreement between two parties to exchange one currency for
another, with the transaction being carried out at once for commercial customers and on the
second following business day for most interbank (i.e., wholesale) trades.

b. Outright forward. A forward transaction is an agreement made today to exchange one currency
for another, with the date of the exchange being a specified time in the future—often one month,
two months, or some other definitive calendar interval. The rate at which the two currencies will
be exchanged is set today.

c. Forward-forward swaps. A more sophisticated swap transaction is called a “forward-forward”
swap. A dealer sells £20,000,000 forward for dollars for delivery in, say, two months at
$1.6870/£ and simultaneously buys £20,000,000 forward for delivery in three months at
$1.6820/£. The difference between the buying price and the selling price is equivalent to the
interest rate differential, i.e., interest rate parity, between the two currencies. Thus, a swap can be
viewed as a technique for borrowing another currency on a fully collateralized basis.

6. Swap Transactions. Define and differentiate the different type of swap transactions in the foreign
exchange markets.

A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates. Both purchase and sale are conducted with the
same counterparty. There are several types of swap transactions.

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Spot Against Forward. The most common type of swap is a “spot against forward.” The dealer buys
a currency in the spot market (at the spot rate) and simultaneously sells the same amount back to the
same bank in the forward market (at the forward exchange rate). Because this is executed as a single
transaction, with just one counterparty, the dealer incurs no unexpected foreign exchange risk. Swap
transactions and outright forwards combined made up more than half of all foreign exchange market
activity in recent years.

Forward-Forward Swaps. A more sophisticated swap transaction is called a forward-forward swap.
For example, a dealer sells £20,000,000 forward for dollars for delivery in, say, two months at
$1.8420/£ and simultaneously buys £20,000,000 forward for delivery in three months at $1.8400/£.
The difference between the buying price and the selling price is equivalent to the interest rate
differential, which is the interest rate parity described in Chapter 6, between the two currencies. Thus,
a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis.

Nondeliverable Forwards (NDFs). Created in the early 1990s, the nondeliverable forward (NDF) is
now a relatively common derivative offered by the largest providers of foreign exchange derivatives.
NDFs possess the same characteristics and documentation requirements as traditional forward
contracts, except that they are settled only in U.S. dollars; the foreign currency being sold forward or
bought forward is not delivered.

7. Nondeliverable Forward. What is a nondeliverable forward, and why does it exist?

The nondeliverable forward (NDF) is now a relatively common derivative offered by the largest
providers of foreign exchange derivatives. NDFs possess the same characteristics and documentation
requirements as traditional forward contracts, except that they are settled only in U.S. dollars; the
foreign currency being sold forward or bought forward is not delivered.

The dollar-settlement feature reflects the fact that NDFs are contracted offshore, for example in New
York for a Mexican investor, and so are beyond the reach and regulatory frameworks of the home
country governments (Mexico in this case). NDFs are traded internationally using standards set by the
International Swaps and Derivatives Association (ISDA). Although originally envisioned to be a
method of currency hedging, it is now estimated that more than 70% of all NDF trading is for
speculation purposes.

8. Foreign Exchange Market Characteristics. With reference to foreign exchange turnover in 2010:

a. Rank the relative size of spot, forwards, and swaps as of 2007. Ranking: 1. Swaps; 2. Spot;
3. Forwards

b. Rank the five most important geographic locations for foreign exchange turnover. Ranking:
1. United Kingdom; 2. United States; 3. Singapore (just barely passing Japan); 4. Japan (used to
be third); 5. Hong Kong (rising rapidly)

c. Rank the three most important currencies of denomination. Ranking: 1. U.S. dollar; 2. European
euro; 3. Japanese yen

9. Foreign Exchange Rate Quotations. Define and give an example of each of the following quotes:

a. Bid rate quote.

b. Ask rate quote.

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Interbank quotations are given as a bid and ask (also referred to as offer). A bid is the price (i.e.,
exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i.e.,
exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask
(sell) at a slightly higher price, making their profit from the spread between the buying and selling
prices.

Bid and ask quotations in the foreign exchange markets are superficially complicated by the fact that
the bid for one currency is also the offer for the opposite currency. A trader seeking to buy dollars
with Swiss francs is simultaneously offering to sell Swiss francs for dollars. Assume a bank makes
the quotations shown in the top half of Exhibit 6.5 for the Japanese yen. The spot quotations on the
first line indicate that the bank’s foreign exchange trader will buy dollars (i.e., sell Japanese yen) at
the bid price of ¥118.27 per dollar. The trader will sell dollars (i.e., buy Japanese yen) at the ask price
of ¥118.37 per dollar.

10. Reciprocals. Convert the following indirect quotes to direct quotes and direct quotes to indirect
quotes:

a. Euro: €1.22/$ (indirect quote); 1/1.22 = $0.8197/€ (direct)

b. Russia: Rub 30/$ (indirect quote); 1/30 = $0.0333/Rub (direct)

c. Canada: $0.72/C$ (direct quote); 1/0.72 = C$1.3889/$ (indirect)

d. Denmark: $0.1644/DKr (direct quote); 1/0.1644 = Dkr 6.0827/$ (indirect)

11. Geographical Extent of the Foreign Exchange Market.

a. What is the geographical location? All countries.

b. What are the two main types of trading systems? (1) Trading on an exchange or exchange floor
and (2) telecommunications linkages.

c. How are foreign exchange markets connected for trading activities? Telecommunications
linkages.

12. American and European Terms. With reference to interbank quotations, what is the difference
between American terms and European terms?

Most foreign currencies in the world are stated in terms of the number of units of foreign currency
needed to buy one dollar. For example, the exchange rate between U.S. dollars and Swiss franc is
normally stated

SF1.6000/$, read as “1.6000 Swiss francs per dollar”

This method, called European terms, expresses the rate as the foreign currency price of one U.S.
dollar. An alternative method is called American terms. The same exchange rate above expressed in
American terms is

$0.6250/SF, read as “0.6250 dollars per Swiss franc”

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Under American terms, foreign exchange rates are stated as the U.S. dollar price of one unit of
foreign currency. Note that European terms and American terms are reciprocals:

1
USD 0.6250 / SF
SF1.60000 / USD
=

With several exceptions, including two important ones, most interbank quotations around the world
are stated in European terms. Thus, throughout the world the normal way of quoting the relationship
between the Swiss franc and U.S. dollar is SF1.6000/$; this method may also be called “Swiss terms.”
A Japanese yen quote of ¥118.32/$ is called “Japanese terms,” although the expression “European
terms” is often used as the generic name for Asian as well as European currency prices of the dollar.
European terms were adopted as the universal way of expressing foreign exchange rates for most (but
not all) currencies in 1978 to facilitate worldwide trading through telecommunications

13. Direct and Indirect Quotes. Define and give an example of the following:

a. An example of a direct quote between the U.S. dollar and the Mexican peso, where the United
States is designated as the home country.

A direct quote is a home currency price of a unit of foreign currency. An example, using Mexico
and the United States (home country) is $0.1050/Peso.

b. An example of an indirect quote between the Japanese yen and the Chinese renminbi (yuan),
where China is designated as the home country.

An indirect quote is a foreign currency price of a unit of home currency. An example, using Japan
and China (home country) is ¥14.75/Rmb.

14. Base and Price Currency. Define base currency, unit currency, price currency, and quote currency.

Foreign exchange quotations follow a number of principles, which at first may seem a bit confusing
or nonintuitive. Every currency exchange involves two currencies, currency 1 (CUR1) and currency 2
(CUR2):

CUR1/CUR2

The currency to the left of the slash is called the base currency or the unit currency. The currency to
the right of the slash is called the price currency or quote currency. The quotation always indicates
the number of units of the price currency, CUR2, required in exchange for receiving one unit of the
base currency, CUR1.

For example, the most commonly quoted currency exchange is that between the U.S. dollar and the
European euro. For example, a quotation of

EUR/USD 1.2174

designates the euro (EUR) as the base currency, the dollar (USD) as the price currency, and the
exchange rate is If you can remember that the currency quoted on the left of the slash is always the
base currency, and always a single unit, you can avoid confusion. Exhibit 5.6 provides a brief

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overview of the multitude of terms often used around the world to quote currencies through an
example using the European euro and U.S. dollar.

15. Cross Rates and Intermarket Arbitrage. Why are cross currency rates of special interest when
discussing intermarket arbitrage?

Because many currencies are traded in volume against a single other currency, cross rates can be used
to check on opportunities for intermarket arbitrage. These arbitrage opportunities arise when a
currency like the Mexican peso, which is traded heavily against the U.S. dollar, may have profit
opportunities arise when the dollar rises or falls against a third currency like the Brazilian real or the
Chilean peso, which are also traded against the Mexican peso.

16. Percentage Change in Exchange Rates. Why do percentage change calculations end up being rather
confusing on occasion?

Unlike the price of a share of stock or an orange, an exchange rate is the price of one money in terms
of a second money. Confusion occasionally arises when looking at a commonly quoted exchange rate
like the number of Mexican pesos to exchange for one dollar. If that rate has changed from 10 to 11,
the percentage change can be calculated either of two ways.

Foreign Currency Terms. When the foreign currency price (the price, Ps) of the home currency (the
unit, $) is used, Mexican pesos per U.S. dollar in this case, the formula for the percent change (%Δ)
in the foreign currency becomes

Beginning Rate Ending Rate 10.00 / $ 11.00 / $
% 100 100 9.09%
Ending Rate 11.00 / $
− =
Δ = × = × = −
Ps Ps
Ps

The Mexican peso fell in value 9.09% against the dollar. Note that it takes more pesos per dollar,
and the calculation resulted in a negative value, both characteristics of a fall in value.

Home Currency Terms. When the home currency price (the price) for a foreign currency (the unit)
is used – the reciprocals of the numbers above – the formula for the percent change in the foreign
currency is:

Beginning Rate Ending Rate $0.09091 / $0.1000 /
% 100 100 9.09%
Ending Rate $0.1000 /
− =
Δ = × = × = −
Ps Ps
Ps

The calculation yields the identical percentage change, a fall in the value of the peso by 9.09%.
Although many people find the second calculation, the home currency term calculation, to be the
more “intuitive” because it reminds them of many percentage change calculations, one must be
careful to remember that these are exchanges of currency for currency, and the currency that is
designated as home currency is significant.

© 2016 Pearson Education, Inc.
CHAPTER 6
INTERNATIONAL PARITY CONDITIONS

1. Law of One Price. Define the law of one price carefully, noting its fundamental assumptions. Why
are these assumptions so difficult to find in the real world in order to apply the theory?

If identical products or services can be sold in two different markets, and no restrictions exist on the
sale or transportation of product between markets, the product’s price should be the same in both
markets. This is called the law of one price.

A primary principle of competitive markets is that prices will equalize across markets if frictions or
costs of moving the products or services between markets do not exist. If the two markets are in two
different countries, the product’s price may be stated in different currency terms, but the price of the
product should still be the same. Comparing prices would require only a conversion from one
currency to the other. For example,

$ ¥ ,× =P S P

where the price of the product in U.S. dollars, P$, multiplied by the spot exchange rate (S, yen per
U.S. dollar), equals the price of the product in Japanese yen, P¥. Conversely, if the prices of the two
products were stated in local currencies, and markets were efficient at competing away a higher price
in one market relative to the other, the exchange rate could be deduced from the relative local product
prices:

¥
$=
P
S
P

The challenge in applying the theory in the real world is that few products exist that are truly identical
across markets, and if they are identical, are truly “transportable” across markets with nearly zero
transportation costs and fees.

2. Purchasing Power Parity. Define the following terms:

a. The law of one price. 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).

b. Absolute purchasing power parity. If the law of one price were true for all goods and services,
the purchasing power parity (PPP) exchange rate could be found from any individual set of
prices. By comparing the prices of identical products denominated in different currencies, one
could determine the “real” or PPP exchange rate which should exist if markets were efficient.
This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the
spot exchange rate is determined by the relative prices of similar baskets of goods.

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c. Relative purchasing power parity. If the assumptions of the absolute version of PPP theory are
relaxed a bit more, we observe what is termed relative purchasing power parity. This more
general idea is that PPP is not particularly helpful in determining what the spot rate is today, but
that the relative change in prices between two countries over a period of time determines the
change in the exchange rate over that period. More specifically, if the spot exchange rate between
two countries starts in equilibrium, any change in the differential rate of inflation between them
tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

3. Big Mac Index. How close does the Big Mac Index conform to the theoretical requirements for a one
price measurement of purchasing power parity?

The Big Mac may be a good candidate for the application of the law of one price and measurement of
under or overvaluation for a number of reasons. First, the product itself is nearly identical in each
market. This is the result of product consistency, process excellence, and McDonald’s brand image
and pride. Second, and just as important, the product is a result of predominantly local materials and
input costs. This means that its price in each country is representative of domestic costs and prices
and not imported ones, which would be influenced by exchange rates themselves. The index,
however, still possesses limitations. Big Macs cannot be traded across borders, and costs and prices
are influenced by a variety of other factors in each country market, such as real estate rental rates and
taxes.

4. Undervaluation and Purchasing Power Parity. According to the theory of purchasing power parity,
what should happen to a currency which is undervalued?

Theoretically, if the currency is undervalued then market participants, in search of potential profits,
will continue to purchase the currency until they drive its price up eliminating the undervaluation.

5. Nominal Effective Exchange Rate Index. Explain how a nominal effective exchange rate index is
constructed.

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
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.

6. Real Effective Exchange Rate Index. What formula is used to convert a nominal effective exchange
rate index into a real effective exchange rate index?

A 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.

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The real effective exchange rate index for the U.S. dollar, E$R, is found by multiplying the nominal
effective exchange rate index, E$N, by the ratio of U.S. dollar costs, C$, over foreign currency costs,
CFC, both in index form:
$
$ $= ×R N FC
C
E E
C

7. Exchange Rate Pass-Through. Incomplete exchange rate pass-through is one reason that a
country’s real effective exchange rate can deviate for lengthy periods from its purchasing power
equilibrium level of 100. What is meant by the term exchange rate pass-through?

Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate
index can deviate for lengthy periods from its PPP-equilibrium level of 100. The degree to which the
prices of imported and exported goods change as a result of exchange rate changes is termed pass-
through. Although PPP implies that all exchange rate changes are passed through by equivalent
changes in prices to trading partners, empirical research in the 1980s questioned this long-held
assumption. For example, sizable current account deficits of the United States in the 1980s and 1990s
did not respond to changes in the value of the dollar.

8. Partial Exchange Rate Pass-Through. What is partial exchange rate pass-through, and how can it
occur in efficient global markets?

Partial pass-through is when prices of imported products rise by less than the full percentage change
in the imported product’s currency. Many times an exporter that finds its price has risen in target
foreign markets as a result of the exporter’s currency appreciating will attempt to keep the price from
rising in the target market by as much as the exchange rate change, wishing to not lose sales as a
result of the price increase. This means that the exporter, if not changing their cost structure, is
earning a smaller margin on the sale.

9. Price Elasticity of Demand. How is the price elasticity of demand relevant to exchange rate pass-
through?

The concept of price elasticity of demand is useful when determining the desired level of pass-
through. Recall that the price elasticity of demand for any good is the percentage change in quantity
of the good demanded as a result of the percentage change in the good’s price:

%
Price elasticity of demand
%
Δ
= =
Δ
d
p
Q
e
P

where Qd is quantity demanded and P is product price. If the absolute value of ep is less than 1.0, then
the good is relatively “inelastic.” If it is greater than 1.0, the good is relatively “elastic.”

A German product that is relatively price-inelastic, meaning that the quantity demanded is relatively
unresponsive to price changes, may often demonstrate a high degree of pass-through. This is because
a higher dollar price in the U.S. market would have little noticeable effect on the quantity of the
product demanded by consumers. Dollar revenue would increase, but euro revenue would remain the
same.

However, products that are relatively price-elastic would respond in the opposite way. If the 20%
euro appreciation resulted in 20% higher dollar prices, U.S. consumers would decrease the number of

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BMWs purchased. If the price elasticity of demand for BMWs in the United States were greater than
one, total dollar sales revenue of BMWs would decline.

10. The Fisher Effect. Define the Fisher effect. To what extent do empirical test confirm that the Fisher
effect exists in practice?

The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each
country are equal to the required real rate of return plus compensation for expected inflation. More
formally, this is derived from (1 + r)(1 + π) – 1:

π π= + +i r r

where i is the nominal rate of interest, r is the real rate of interest, and π is the expected rate of
inflation over the period of time for which funds are to be lent.

11. Approximate Form of Fisher Effect.

The final compound term, r times π, is frequently dropped from consideration due to its relatively
minor value. The Fisher effect then reduces to (approximate form):

π= +i r

The Fisher effect applied to two different countries like the United States and Japan would be:

$ $ $ ¥ ¥ ¥;π π= + = +i r i r

where the superscripts $ and ¥ pertain to the respective nominal (i), real (r), and expected inflation (π)
components of financial instruments denominated in dollars and yen, respectively. We need to
forecast the future rate of inflation, not what inflation has been. Predicting the future can be difficult.

12. The International Fisher Effect. Define the international Fisher effect. To what extent do empirical
tests confirm that the international Fisher effect exists in practice?

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
100
−
× = −
S S
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

Chapter 6 International Parity Conditions 35

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end of the period (S2). This is the approximation form commonly used in industry. The precise
formulation is:

$ ¥
1 2
¥
2 1
− −
=
+
S S i i
S i

Empirical tests using ex-post national inflation rates have shown the Fisher effect usually exists for
short-maturity government securities, such as treasury bills and notes. Comparisons based on longer
maturities suffer from the increased financial risk inherent in fluctuations of the market value of the
bonds prior to maturity. Comparisons of private sector securities are influenced by unequal
creditworthiness of the issuers. All the tests are inconclusive to the extent that recent past rates of
inflation are not a correct measure of future expected inflation.

13. Interest Rate Parity. Define interest rate parity. What is the relationship between interest rate parity
and forward rates?

The theory of interest rate parity (IRP) provides the linkage between the foreign exchange markets
and the international money markets. The theory states: The difference in the national interest rates
for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate
discount or premium for the foreign currency, except for transaction costs.

14. Covered Interest Arbitrage. Define the terms covered interest arbitrage and uncovered interest
arbitrage. What is the difference between these two transactions?

The spot and forward exchange markets are not, however, constantly in the state of equilibrium
described by interest rate parity. When the market is not in equilibrium, the potential for “riskless” or
arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage
of the disequilibrium by investing in whichever currency offers the higher return on a covered basis.
This is called covered interest arbitrage (CIA).

15. Uncovered Interest Arbitrage. Define uncovered interest arbitrage and explain what expectations an
investor or speculator would need to undertake an uncovered interest arbitrage investment?

A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors
borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds
into currencies that offer much higher interest rates. The transaction is “uncovered” because the
investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered
and accept the currency risk of exchanging the higher yield currency into the lower yielding currency
at the end of the period.

Exhibit 6.8 demonstrates the steps an uncovered interest arbitrager takes when undertaking what is
termed the yen carry trade. Borrowing in the Japanese yen market has always been desirable as yen
interest rates are frequently very low, Japanese banks— which are large—are frequently interested in
lending to multinational companies, and the yen itself may hold its value for long periods of time.

16. Forward Rate Calculation. If someone you were working with argued that the current forward rate
quoted on a currency pair is the market’s expectation of where the future spot rate will end up, what
would you say?

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This is a common misconception. The forward rate is a calculation, using three observable market
rates: the spot exchange rate, the domestic interest rate, and the foreign interest rate. It is technically
categorized as a foreign currency loan agreement by the financial institution, and the rate makes that
evident. There is no “predictive” element in its calculation, although many people in the market
commonly use it as a forecast. In fact, the forward rate has been repeatedly tested over time as to its
forecasting accuracy, and it generally performs pretty well when forecasting out 30 to 90 days.

17. Forward Rate as an Unbiased Predictor of the Future Spot Rate. Some forecasters believe that
foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates
are unbiased predictors of future spot exchange rates. What is meant by “unbiased predictor” in terms
of how the forward rate performs in estimating future spot exchange rates?

Some forecasters believe that foreign exchange markets for the major floating currencies are
“efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.

Exhibit 6.10 demonstrates the meaning of “unbiased prediction” in terms of how the forward rate
performs in estimating future spot exchange rates. If the forward rate is an unbiased predictor of the
future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for
time 2 delivery, available now, E(S2) = F1.

Intuitively this means that the distribution of possible actual spot rates in the future is centered on the
forward rate. The fact that it is an unbiased predictor, however, does not mean that the future spot rate
will actually be equal to what the forward rate predicts. Unbiased prediction simply means that the
forward rate will, on average, overestimate and underestimate the actual future spot rate in equal
frequency and degree. The forward rate may, in fact, never actually equal the future spot rate.

The rationale for this relationship is based on the hypothesis that the foreign exchange market is
reasonably efficient. Market efficiency assumes that (1) all relevant information is quickly reflected
in both the spot and forward exchange markets, (2) transaction costs are low, and (3) instruments
denominated in different currencies are perfect substitutes for one another.

18. Transaction Costs. If transaction costs for undertaking covered or uncovered interest arbitrage were
large, how do you think it would influence arbitrage activity?

It would result in large discrepancies between market rates and quotes, as a higher transaction cost
would dissuade many arbitragers from making the trades for small amounts.

19. Carry Trade. The term carry trade is used quite frequently in the business press. What does it mean,
and what conditions and expectations do investors need to hold to undertake carry trade transactions?

The carry trade refers to borrowing in a low interest rate environment, for example Japan, and then
investing the proceeds in a higher rate environment, say the Australian dollar, to earn the differential.
It is a risky position in that if the debt currency (the yen in this case) were to appreciate in value
during the period, the exchange rate change can easily wipe out all interest earnings returns. The
borrower therefore needs to expect the borrowing currency’s value to remain relatively unchanged
over the period (or even fall in value against the currency of the investment).

Chapter 6 International Parity Conditions 37

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20. Market Efficiency. Many academics and professionals have tested the foreign exchange and interest
rate markets to determine their efficiency. What have they concluded?

Tests of foreign exchange market efficiency conclude that either exchange market efficiency is
untestable or, if it is testable, that the market is not efficient. The existence and success of foreign
exchange forecasting services suggest that managers are willing to pay a price for forecast
information even though they can use the forward rate as a forecast at no cost. The “cost” of buying
this information is, in many circumstances, an “insurance premium” for financial managers who
might get fired for using their own forecast, including forward rates, when that forecast proves
incorrect.

© 2016 Pearson Education, Inc.
CHAPTER 7
FOREIGN CURRENCY DERIVATIVES:
FUTURES AND OPTIONS

1. Foreign Currency Futures. What is a foreign currency future?

A future is an exchange-traded contract calling for future delivery of a standard amount of foreign
currency at a fixed time, place, and price. A future requires a mandatory delivery. The future is a
standardized exchange-traded contract often used as an alternative to a forward foreign exchange
agreement.

2. Futures Terminology. Explain the meaning and probable significance for international business of
the following contract specifications:

Specific-sized contract: Trading may be conducted only in preestablished multiples of currency units.
This means that a firm wishing to hedge some aspect of its foreign exchange risk is not able to match
the contract size with the size of the risk.

Standard method of stating exchange rates. Rates are stated in “American terms,” meaning the U.S.
dollar value of the foreign currency, rather than in the more generally accepted “European terms,”
meaning the foreign currency price of a U.S. dollar. This has no conceptual significance, although
financial managers used to viewing exposure in European terms will find it necessary to convert to
reciprocals.

Standard maturity date. All contracts mature at a preestablished date, being on the third Wednesday
of eight specified months. This means that a firm wishing to use foreign exchange futures to cover
exchange risk will not be able to match the contract maturity with the risk maturity.

Collateral and maintenance margins. An initial “margin,” meaning a cash deposit made at the time a
futures contract is purchased, is required. This is an inconvenience to most firms doing international
business because it means some of their cash is tied up in a unproductive manner. Forward contracts
made through banks for existing business clients do not normally require an initial margin. A
maintenance margin is also required, meaning that if the value of the contract is marked to market
every day and if the existing margin on deposit falls below a mandatory percentage of the contract,
additional margin must be deposited. This constitutes a big nuisance to a business firm because it
must be prepared for a daily outflow of cash than cannot be anticipated. (Of course, on some days the
cash flow would be in to the firm.)

Counterparty. All futures contracts are with the clearinghouse of the exchange where they are traded.
Consequently a firm or individual engaged in buying or selling futures contracts need not worry about
the credit risk of the opposite party.

3. Long and a Short. How do you use foreign currency futures to speculate on the exchange rate
movements, and what role do long and short positions play in that speculation?

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Short Positions. If a currency speculator believes that a foreign currency will fall in value versus the
U.S. dollar (home currency) by a specific date, she could sell that date futures contract, taking a short
position. By selling that date contract, the speculator locks in the right to sell the foreign currency at a
set price—a price that the speculator believes would be higher than the spot rate in the market on that
future date.

Long Positions. If a currency speculator believes that a foreign currency will rise in value versus the
home currency by a specific date, she should buy a specific future date future on the foreign currency.
By buying a currency future, the speculator is locking in the price to buy the foreign currency, which
the speculator expects to be higher in value at that date, therefore generating a profit.

4. Futures and Forwards. How do foreign currency futures and foreign currency forwards compare?

Foreign currency futures contracts differ from forward contracts in a number of important ways.
Individuals find futures contracts useful for speculation because they usually do not have access to
forward contracts. For businesses, futures contracts are often considered inefficient and burdensome
because the futures position is marked to market on a daily basis over the life of the contract.
Although this does not require the business to pay or receive cash daily, it does result in more
frequent margin calls from its financial service providers than the business typically wants.

5. Puts and Calls. Define a put and call on the British pound sterling.

A put option on the British pound would give the holder—the buyer of the put option—the right
but not the obligation to sell British pounds at a future date at a specific rate.

A call option on the British pound would give the holder—the buyer of the call option—the right
but not the obligation to buy British pounds at a future date at a specific rate.

6. Options versus Futures. Explain the difference between foreign currency options and futures and
when either might be most appropriately used.

An option is a contract giving the buyer the right but not the obligation to buy or sell a given amount
of foreign exchange at a fixed price for a specified time period. A future is an exchange-traded
contract calling for future delivery of a standard amount of foreign currency at a fixed time, place,
and price.

The essence of the difference is that an option leaves the buyer with the choice of exercising or not
exercising. The future requires a mandatory delivery. The future is a standardized exchange-traded
contract often used as an alternative to a forward foreign exchange agreement.

7. Call Option Contract. You read that exchange-traded American call options on pounds sterling
having a strike price of 1.460 and a maturity of next March are now quoted at 3.67. What does this
mean if you are a potential buyer?

If you buy such an option, you may, if you wish, order the writer (opposite party) of the option to
deliver pounds sterling to you, and you will pay $1.460 for each pound. $1.460/£ is called the “strike
price.” You have this right (this “option”) until next March, and for this right you will pay 3.67¢ per
pound.

The information provided to you does not tell you the size of each option contract, which you would
have to know from general experience or from asking your broker. The contract size for pounds

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sterling on the IMM is £62,500 per contract, meaning that the option will cost you £62,500 × $0.0367
= $2,293.75.

8. Premiums, Prices & Costs. What is the difference between the price of an option, the value of an
option, the premium on an option, and the cost of a foreign currency option?

They all mean the same thing. The price of an option is its premium, its cost, and its value.

9. Three Prices. What are the three different prices or “rates” integral to every foreign currency option
contract?

All currency options have three fundamental prices or rates: (1) the current spot rate;( 2) the chosen
strike rate; and (3) the option premium.

10. Writing Options. Why would anyone write an option, knowing that the gain from receiving the
option premium is fixed but the loss if the underlying price goes in the wrong direction can be
extremely large?

As with all options, what the holder gains, the writer loses, and vice versa. If the writer of a call
option already owns the currency, the writer would be effectively “covered” if the option ends up
being call against the writer. The writer, however, will still experience an opportunity loss,
surrendering against the option the same currency that could have been sold for more in the open
market.

From the option writer’s point of view, only two events can take place:

The option is not exercised. In this case, the writer gains the option premium and still has the
underlying stock.

The option is exercised. If the option writer owns the stock and the option is exercised, the option
writer (1) gains the premium and (2) experiences only an opportunity cost loss. In other words,
the loss is not a cash loss, but rather the opportunity cost loss of having foregone the potential of
making even more profit had the underlying shares been sold at a more advantageous price. This
is somewhat equivalent of having sold (call option writer) or bought (put option writer) at a price
better than current market, only to have the market price move even further in a beneficial
direction.

If the option writer does not own the underlying shares, the option is written “naked.” Only in this
instance can the cash loss to the option writer be unlimited.

11. Decision Prices. Once an option has been purchased, only two prices or rates are part of the holder’s
decision making process. Which two and why?

Once an option has been purchased, the option premium is essentially a sunk cost that no longer
drives any decision making. What matters after purchase is how the option strike rate is positioned in
regard to the current spot rate. Then, depending on the expectations of the investor and the kind of
option purchased, the option will be exercised if in-the-money.

12. Option Cash Flows and Time. The cash flows associated with a call option on euros by a U.S. dollar
based investor occur at different points in time. What are they and how much does the time element
matter?

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The U.S. dollar investor purchases the option up-front. This is the initial up-front cash outlay for the
option “right,” but also represents the total maximum loss. The buyer of an option cannot lose more
than the cost of the option, the premium. Upon expiration or exercise, if the option is in the money the
investor will exercise the option for profit and a cash settlement on the option. If the option is allowed
to expire out-of-the-money, there is no secondary cash flow associated with the option. There is no
cash exchange with expiration. The time between option purchase and maturity can be very short or
very long, but the time value does not alter the value proposition or decision principles followed by
the investor.

13. Option Valuation. The value of an option is stated to be the sum of its intrinsic value and its time
value. Explain what is meant by these terms.

Intrinsic value for a call option is the amount of gain that would be made today if the option were
exercised today and the underlying shares sold immediately. For a put, intrinsic value is the amount
of gain that would be made if the underlying shares were purchased today and delivered immediately
against the option. Intrinsic value can be zero, as when the option is not worth exercising today.
However, if a gain could be made by exercising the option today, the intrinsic value is positive
because intrinsic value can never be less than what can be gained from an immediate exercise of the
option. Note that gain is not the same as net profit because in all cases the option buyer has already
paid the premium.

Time value of an option is related to what one will pay above intrinsic value because of the chance
that between today and the maturity of the option intrinsic value will become positive (option with no
intrinsic value) or greater than today (option having some positive intrinsic value today). In effect,
intrinsic value is the worth of the speculative component of the option.

14. Time Value Deterioration. An option’s value declines over time, but it does not do it evenly.
Explain what that means for option valuation.

Option premiums deteriorate at an increasing rate as they approach expiration; they do not deteriorate
linearly. In fact, the majority of the option premium— depending on the individual option— may be
lost in the final one-third of the option’s life prior to maturity/expiration.

15. Option Values and Money. Options are often described as in-the-money, at-the-money, or out-of-
the-money. What does that mean and how is it determined?

If an option could currently be exercised for a profit it is in-the-money. If the current spot rate is the
same as the option’s strike rate, it is at-the-money. If the option is not currently exercisable for a
profit it is out-of-the-money.

16. Option Pricing and the Forward Rate. What is the relationship or link between the forward rate and
the foreign currency option premium?

Because foreign currency option premiums using the current spot exchange rate and both the
domestic and foreign interest rate in their pricing, and those same three elements are the necessary
components for calculation of the forward rate, foreign currency options have an implicit forward rate
embedded in their pricing and valuation.

17. Option Deltas. What is an option delta? How does it change when the option is in-the-money, at-the-
money, or out-of-the-money?

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18. Historic Versus Implied Volatility. What is the difference between a historic volatility and an
implied volatility?

Historic volatility is the standard deviation of daily spot rates as calculated over a historical period of
time. It is observable, historical, data. Implied volatility is the estimation of the volatility that is
“back-out” of an option price (premium) as a result of trading in the market.

© 2016 Pearson Education, Inc.
CHAPTER 8
INTEREST RATE RISK AND SWAPS

1. Reference Rates. What is an interest “reference rate,” and how is it used to set rates for individual
borrowers?

A reference rate—for example, U.S. dollar LIBOR—is the rate of interest used in a standardized
quotation, loan agreement, or financial derivative valuation. LIBOR, the London Interbank Offered
Rate, is by far the most widely used and quoted.

2. My Word is My LIBOR. Why has LIBOR played such a central role in international business and
financial contracts? Why has this been questioned in recent debates over its value reported?

No single interest rate is more fundamental to the operation of the global financial markets than the
London Interbank Offered Rate (LIBOR). But beginning as early as 2007, a number of participants in
the interbank market on both sides of the Atlantic suspected that there was trouble with LIBOR. The
three-month and six-month maturities are the most significant maturities due to their widespread use
in various loan and derivative agreements, with the dollar and the euro being the most widely used
currencies.

The issues related to LIBOR have been increasingly complicated in recent years—beginning with the
origin of the rates submitted by banks. First, rates are based on “estimated borrowing rates” to avoid
reporting only actual transactions, as many banks may not conduct actual transactions in all maturities
and currencies each day. As a result, the origin of the rate submitted by each bank becomes, to some
degree, discretionary.

Secondly, banks—specifically money-market and derivative traders within the banks—have a number
of interests that may be impacted by borrowing costs reported by the bank that day. One such
example can be found in the concerns of banks in the interbank market in September 2008, when the
credit crisis was in full bloom. A bank reporting that other banks were demanding it pay a higher rate
that day would, in effect, be self-reporting the market’s assessment that it was increasingly risky. In
the words of one analyst, akin “to hanging a sign around one’s neck that I am carrying a contagious
disease.” Market analysts are now estimating that many of the banks in the LIBOR panel were
reporting borrowing rates that were anywhere from 30 to 40 basis points lower than actual rates
throughout the financial crisis.

3. Credit Risk Premium. What is a credit risk premium?

The cost of debt for any individual borrower will therefore possess two components, the risk-free rate
of interest (kUS$), plus a credit risk premium (RPM$Rating) reflecting the assessed credit quality of the
individual borrower. For an individual borrower in the United States, the cost of debt (kDebt$) would
be:

kDebt$ = kUS$ + RPM$Rating

The credit risk premium represents the credit risk of the individual borrower. In credit markets, this
assignment is typically based on the borrower’s credit rating as designated by one of the major credit

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rating agencies, Moody’s, Standard & Poors, and Fitch. An overview of those credit ratings is
presented in Exhibit 8.3. Although each agency utilizes different methodologies, all include the
industry in which the firm operates, its current level of indebtedness, its past, present, and prospective
operating performance, among a multitude of other factors.

4. Credit and Repricing Risk. From the point of view of a borrowing corporation, what are credit and
repricing risks? Explain steps a company might take to minimize both.

For a corporate borrower, it is especially important to distinguish between credit risk and repricing
risk. Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s creditworthiness
at the time of renewing a credit—its credit rating—is reclassified by the lender. This can result in
changing fees, changing interest rates, altered credit line commitments, or even denial. Repricing risk
is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset.
A borrower that is renewing a credit will face current market conditions on the base rate used for
financing, a true floating-rate.

5. Credit Spreads. What is a credit spread? What credit rating changes have the most profound impact
on the credit spread paid by corporate borrowers?

The cost of debt changes with credit quality, as a credit spread is added to the basic Treasury rate for
the maturity in question. The costs of credit quality—credit spreads—are quite minor for borrowers
of investment grade but rise dramatically for speculative grade borrowers.

6. Investment Grade Versus Speculative Grade. What do the general categories of investment grade
and speculative grade represent?

Although there is obviously a wide spectrum of credit ratings, the designation of investment grade
versus speculative grade is extremely important. An investment grade borrower (Baa3, BBB-, and
above) is considered a high-quality borrower that is expected to be able to repay a new debt
obligation in a timely manner regardless of market events or business performance. A speculative
grade borrower (Ba1 or BB+ and below) is believed to be a riskier borrower and, depending on the
nature of a market downturn or business shock, may have difficulty servicing new debt.

7. Sovereign Debt. What is sovereign debt? What specific characteristic of sovereign debt constitutes
the greatest risk to a sovereign issuer?

Debt issued by governments—sovereign debt—is historically considered debt of the highest quality,
higher than that of non-government borrowers within that same country. This quality preference
stems from the ability of a government to tax its people and, if need be, print more money. Although
the first may cause significant economic harm in the form of unemployment and the second
significant financial harm in the form of inflation, they are both tools available to the sovereign. The
government therefore has the ability to service its own debt, one way or another, when that debt is
denominated in its own currency. When that debt is denominated in a foreign currency, however,
servicing that debt can potentially pose a great risk to the sovereign issuer.

8. Floating Rate Loan Risk. Why do borrowers of lower credit quality often find their access limited to
floating-rate loans?

As opposed to fixed rate loans, where the lender accepts both the risk of changing interest rates and
changing credit quality of the borrower on loan origination, a floating-rate loan shifts interest rate risk

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to the borrower. Lenders are not generally willing to accept both risks when lending to lower credit
quality borrowers.

9. Interest Rate Futures. What is an interest rate future? How can they be used to reduce interest rate
risk by a borrower?

Interest rate futures are relatively widely used by financial managers and treasurers of nonfinancial
companies. Their popularity stems from the high liquidity of the interest rate futures markets, their
simplicity in use, and the rather standardized interest rate exposures most firms possess.

If a financial manager were interested in hedging a floating-rate interest payment due at a short-term
future date, she would need to sell a future to take a short position. This strategy is referred to as a
short position because the manager is selling something she does not own (as in shorting common
stock). If interest rates rise by March, as the manager fears, the futures price will fall, and she will be
able to close the position at a profit. This profit will roughly offset the losses associated with rising
interest payments on her debt. If the manager is wrong, however, and interest rates actually fall by the
maturity date, causing the futures price to rise, she will suffer a loss that will wipe out the “savings”
derived from making a lower floating-rate interest payment than she expected. So by selling the
futures contract, the manager locks-in an interest rate.

10. Interest Rate Futures Strategies. What would be the preferred strategy for a borrower paying
interest on a future date if they expected interest rates to rise?

They should sell an interest rate futures—take a short position.

11. Forward Rate Agreement. How can a business firm that has borrowed on a floating-rate basis use a
forward rate agreement to reduce interest rate risk?

A forward rate agreement (FRA) is an interbank-traded contract to buy or sell interest rate payments
on a notional principal. These contracts are settled in cash. The buyer of an FRA obtains the right to
lock in an interest rate for a desired term that begins at a future date. The contract specifies that the
seller of the FRA will pay the buyer the increased interest expense on a nominal sum (the notional
principal) of money if interest rates rise above the agreed rate, but the buyer will pay the seller the
differential interest expense if interest rates fall below the agreed rate. Maturities available are
typically 1, 3, 6, 9, and 12 months, much like traditional forward contracts for currencies.

12. Plain Vanilla. What is a plain vanilla interest rate swap? Are swaps a significant source of capital for
multinational firms?

A plain vanilla interest rate swap is a swap to pay fixed/receive floating, or alternatively, pay
floating/receive fixed. The plain vanilla interest rate swap is not a source of capital; it only alters the
interest rate price on repayment of a theoretical—notional—debt principal.

13. Swaps and Credit Quality. If interest rate swaps are not the cost of government borrowing, what
credit quality do they represent?

Although in principle the swap market does not “price” or “trade” credit quality, the fundamental
fixed rates of interest used by the swap market are based on AA credit quality borrowers.

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14. LIBOR Flat. Why do fixed for floating interest rate swaps never swap the credit spread component
on a floating rate loan?

Interest rate swaps are not sources of capital and, therefore, are not intended to price debt as a market
or banker would in assessing a borrower’s credit quality. Instead, the swap market only alters the
repayment mechanism of existing debt. Because floating-rate loans are priced at LIBOR + a credit
risk premium, and the market is not assessing credit risk, the credit risk premium adjustment to
LIBOR on interest rate swaps is zero or flat.

15. Debt Structure Swap Strategies. How can interest rate swaps be used by a multinational firm to
manage its debt structure?

All companies will pursue a target debt structure that combines maturity, currency of composition,
and fixed/floating pricing. The fixed/floating objective is one of the most difficult for many
companies to determine with any confidence, and they often just try to replicate industry averages.

Companies that have very high credit quality and therefore advantaged access to the fixed-rate debt
markets, companies of A or AA like WalMart or IBM, often raise large amounts of debt in long
maturities at fixed rates. They then use the plain vanilla swap market to alter selective amounts of
their fixed-rate debt into floating-rate debt to achieve their desired objective. Swaps allow them to
alter the fixed/floating composition quickly and easily without the origination and registration fees of
the direct debt markets.

Companies of lower credit quality, sometimes those of less than investment grade, often find the
fixed-rate debt market not open to them. Getting fixed-rate debt is either impossible or too costly.
They will generally raise their debt at floating-rates and then periodically evaluate whether the plain
vanilla swap market offers any attractive alternatives to swap from paying-floating to paying-fixed.
The plain vanilla swap market is of course also frequently used by many firms to alter their
fixed/floating debt structure to changing interest rate expectations.

16. Cost-Based Swap Strategies. How do corporate borrowers use interest rate or cross currency swaps
to reduce the costs of their debt?

All firms are always interested in opportunities to lower the cost of their debt. The plain vanilla swap
market is one highly accessible and low cost method of doing so.

These lower costs achieved through the plain vanilla swap market may simply reflect short-term
market imperfections and inefficiencies or the comparative advantage some borrowers have in
selected markets via selective financial service providers. The savings may be large—30, 40, or even
50 basis points on occasion—or quite small. It is up to the management of the firm and its corporate
treasury to determine how much savings is needed to spend the time and effort in executing the
swaps. Banks promote the swap market and will regularly market deals to corporate treasuries. A
corporate treasurer once remarked to the author that “unless the proposed structure or deal can save
me 15 or 20 basis points, at a minimum, do not bother calling me to push the deal.”

17. Cross-Currency Swaps. Why would one company with interest payments due in pounds sterling
want to swap those payments for interest payments due in U.S. dollars?

It might be that the company in its continuing business received regular cash inflows in U.S. dollars
and would prefer to match the currency inflows with a same-currency cash outflow. Swapping pounds
sterling interest payments for dollar interest payments would fulfill that objective.

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18. Value Swings in Cross-Currency Swaps. Why are there significantly larger swings in the value of a
cross-currency swap than there is in a plain vanilla interest rate swap?

Cross-currency swaps are subject to both changes in interest rates and changes in exchange rates. The
two risks together combine to cause potentially large swings in the relative legs of the swap structure.

19. Unwinding a Swap. How does a company cancel or unwind a swap?

Unwinding a currency swap requires the discounting of the remaining cash flows under the swap
agreement at current interest rates, then converting the target currency back to the home currency of
the firm.

20. Counterparty Risk. How does organized exchange trading in swaps remove any risk that the
counterparty in a swap agreement will not complete the agreement?

Counterparty risk is the potential exposure any individual firm bears that the second party to any
financial contract will be unable to fulfill its obligations under the contract’s specifications. Concern
over counterparty risk has risen in the interest rate and currency swap markets as a result of a few
large and well-publicized swap defaults. The rapid growth in the currency and interest rate financial
derivatives markets has actually been accompanied by a surprisingly low default rate to date,
particularly in a global market that is, in principle, unregulated.

Counterparty risk has long been one of the major factors that favor the use of exchange-traded rather
than over-the-counter derivatives. Most exchanges, like the Philadelphia Stock Exchange for currency
options or the Chicago Mercantile Exchange for Eurodollar futures, are themselves the counterparty
to all transactions. This allows all firms a high degree of confidence that they can buy or sell
exchange-traded products quickly and with little concern over the credit quality of the exchange itself.
Financial exchanges typically require a small fee of all traders on the exchanges, to fund insurance
funds created expressly to protect all parties. Over-the-counter products, however, are direct credit
exposures to the firm because the contract is generally between the buying firm and the selling
financial institution. Most financial derivatives in today’s world financial centers are sold or brokered
only by the largest and soundest financial institutions. This structure does not mean, however, that
firms can enter continuing agreements with these institutions without some degree of real financial
risk and concern.

© 2016 Pearson Education, Inc.
CHAPTER 9
FOREIGN EXCHANGE RATE DETERMINATION

1. Exchange Rate Determination. What are the three basic theoretical approaches to exchange rate
determination?

The three major schools of thought are (1) purchasing power parity, (2) balance of payments
approach, and (3) asset market approach.

Purchasing Power Parity Approach. The most widely accepted of all exchange rate determination
theories, the theory of purchasing power parity (PPP) states that the long-run equilibrium exchange
rate is determined by the ratio of domestic prices relative to foreign prices, as explained in Chapter 6.
PPP is both the oldest and most widely followed of the exchange rate theories, and most theories of
exchange rate determination have PPP elements embedded within their frameworks.

Balance of Payments Approach. After PPP, the most frequently used theoretical approach to
exchange rate determination is probably that involving the supply and demand for currencies in the
foreign exchange market. These exchange rate flows reflect current account and financial account
transactions recorded in a nation’s balance of payments, as described in Chapter 3. The basic balance
of payments approach argues that the equilibrium exchange rate is found when the net inflow
(outflow) of foreign exchange arising from current account activities matches the net outflow (inflow)
of foreign exchange arising from financial account activities.

Asset Market Approach. The asset market approach, sometimes called the relative price of bonds
or portfolio balance approach, argues that exchange rates are determined by the supply and demand
for financial assets of a wide variety. Shifts in the supply and demand for financial assets alter
exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative
risks of financial assets, which in turn alter rates.

2. PPP Inadequacy. The most widely accepted theory of foreign exchange rate determination is
purchasing power parity, yet it has proven to quit poor at forecasting future spot exchange rates.
Why?

Although PPP seems to possess a core element of common sense, it has proven to be quite poor at
forecasting exchange rates (at least in the short to medium term). The problems are both theoretical
and empirical. The theoretical problems lie primarily with its basic assumption that the only thing that
matters is relative price changes. Yet many currency supply and demand forces are driven by other
forces, including investment incentives, economic growth, and political change. The empirical issues
are primarily in deciding which measures or indexes of prices to use across countries, in addition to
the ability to provide a “predicted change in prices” with the chosen indexes.

3. Data and the Balance of Payments Approach. Statistics on a country’s balance of payments are
used by the business press and business itself often in terms of predicting exchange rates, but the
academic profession is highly critical of it. Why?

Criticisms of the balance of payments approach arise from the theory’s emphasis on flows of currency
and capital rather than on stocks of money or financial assets. Relative stocks of money or financial

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assets play no role in exchange rate determination in this theory, a weakness explored in the following
discussion of monetary and asset market approaches. Curiously, while the balance of payments
approach is largely dismissed by the academic community today, the practitioner public-market
participants, including currency traders themselves, still rely on different variations of this theory for
much of their decision making.

4. Supply and Demand. Which of the three major theoretical approaches seems to put the most weight
into arguments on the supply and demand for currency? What is its primary weakness?

The monetary approach focuses on changes in the supply and demand for money as the primary
determinant of inflation. Changes in relative inflation rates in turn are expected to alter exchange rates
through a purchasing power parity effect. The monetary approach then assumes that prices are
flexible in the short run as well as the long run, so that the transmission mechanism of inflationary
pressure is immediate in impact.

A weakness of monetary models of exchange rate determination is that real economic activity is
relegated to a role in which it only influences exchange rates through changes in the demand for
money. The monetary approach is also criticized for its omission of a number of factors that are
generally agreed upon by area experts as important to exchange rate determination, including (1) the
failure of PPP to hold in the short to medium term; (2) money demand appears to be relatively
unstable over time; and (3) the level of economic activity and the money supply appear to be
interdependent, not independent.

5. Asset Market Approach to Forecasting. 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:

Relative real interest rates are a major consideration for investors in foreign bonds and short-term
money market instruments.
Prospects for economic growth and profitability are an important determinant of cross-border
equity investment in both securities and foreign direct investment.
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.
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.
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.
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.
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.

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

6. Technical Analysis. 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; and (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.

7. Intervention. What is foreign currency intervention? How is it accomplished?

Foreign currency intervention is the active management, manipulation, or intervention in the
market’s valuation of a country’s currency. A short list of the intervention methods would include
direct intervention, indirect intervention, and capital controls.

Direct Intervention. This is the active buying and selling of the domestic currency against foreign
currencies. This traditionally required a central bank to act like any other trader in the currency
market—albeit a big one. If the goal were to increase the value of the domestic currency, the central
bank would purchase its own currency using its foreign exchange reserves, at least to the acceptable
limits that it could endure depleting its reserves.

Indirect Intervention. This is the alteration of economic or financial fundamentals that are thought
to be drivers of capital to flow in and out of specific currencies. This was a logical development for
market manipulation given the growth in size of the global currency markets relative to the financial
resources of central banks.

8. Intervention Motivation. Why do governments and central banks intervene in the foreign exchange
markets? If markets are efficient, why not let them determine the value of a currency?

Historically, a primary motive for a government to pursue currency value change was to keep the
country’s currency cheap so that foreign buyers would find its exports cheap. This policy, long
referred to as “beggar-thy-neighbor,” gave rise to many competitive devaluations over the years. It
has not, however, fallen out of fashion.

Alternatively, the fall in the value of the domestic currency will sharply reduce the purchasing power
of its people. If the economy is forced, for a variety of reasons, to continue to purchase imported
products (e.g., petroleum imports because of no domestic substitute), a currency devaluation or
depreciation may prove highly inflationary and, in the extreme, impoverish the country’s people (as
in the case of Venezuela).

It is frequently noted that most countries would like to see stable exchange rates and to avoid the
entanglements associated with manipulating currency values. Unfortunately, that would also imply
that they are also happy with the current exchange rate’s impact on country-level competitiveness.

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9. Direct Intervention Usefulness. When is direct intervention likely to be the most successful? And
when is it likely to be the least successful?

Direct intervention was the primary method used for many years, but beginning in the 1970s, the
world’s currency markets grew enough that any individual player, even a central bank, could find
itself with insufficient resources to move the market.

10. Intervention Downside. What is the downside of both direct and indirect intervention?

It is important to remember that intervention may—and often does—fail. The Turkish currency crisis
of 2014 is a classic example of a drastic indirect intervention that ultimately only slowed the rate of
capital flight and currency collapse. Turkey had enjoyed some degree of currency stability throughout
2012 and 2013, but the Turkish economy (one of the so-called “Fragile Five” countries, along with
South Africa, India, Indonesia, and Brazil) suffered a widening current account deficit and rising
inflation in late 2013. With the increasing anxieties in emerging markets in the fourth quarter of 2013
over the U.S. Federal Reserve’s announcement that it would be slowing its bond purchasing (the
Taper Program, essentially a tighter monetary policy), capital began exiting Turkey. The lira came
under increasing downward pressure.

11. Capital Controls. Are capital controls really a method of currency market intervention, or more of a
denial of activity? How does this fit with the concept of the impossible trinity?

This is the restriction of access to foreign currency by government. This involves limiting the ability
to exchange domestic currency for foreign currency. When access and exchange is permitted, trading
takes place only with official designees of the government or central bank, and only at dictated
exchange rates.

Often, governments will limit access to foreign currencies to commercial trade: for example, allowing
access to hard currency for the purchase of imports only. Access for investment purposes—
particularly for short-term portfolios in which investors are moving in and out of interest-bearing
accounts, purchasing or selling securities or other funds—is often prohibited or limited. The Chinese
regulation of access and trading of the Chinese yuan is a prime example of the use of capital controls
over currency value—a choice within the framework of the Impossible Trinity. In addition to the
government’s setting the daily rate of exchange, access to the exchange is limited by a difficult and
timely bureaucratic process for approval and is limited to commercial trade transactions.

12. Asian Crisis of 1997 and Disequilibrium. What was the primary disequilibrium at work in Asia in
1997 that likely caused the Asian financial crisis? Do you think it could have been avoided?

The roots of the Asian currency crisis extended from a fundamental change in the economics of the
region, the transition of many Asian nations from being net exporters to net importers. Starting as
early as 1990 in Thailand, the rapidly expanding economies of the Far East began importing more
than they exported, requiring major net capital inflows to support their currencies. As long as the
capital continued to flow in—capital for manufacturing plants, dam projects, infrastructure
development, and even real estate speculation—the pegged exchange rates of the region could be
maintained. When the investment capital inflows stopped, however, crisis was inevitable.

Many analysts argue that if the governments of these Far East nations had given up their pegged
exchange rates earlier, the market adjustment would have been made gradually over time as their
economies changed. Expecting governments to give up on pegged exchange rates, particularly when
they still viewed their economic life-blood to be exports, is not, however, very realistic.

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13. Fundamental Equilibrium. 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 theories outlined in this 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.

14. Argentina’s Failure. What was the basis of the Argentine Currency Board, and why did it fail in
2002?

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 that
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
the Argentine peso did not slide.

15. Term Forecasting. What are the major differences between short-term and long-term forecasts for a
fixed exchange rate versus a 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

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important as technical factors in the marketplace, government intervention, news, and passing whims
of traders and investors. Accuracy of the forecast is critical because most of the exchange rate
changes are relatively small even though the day-to-day volatility may be high.

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 9.9 summarizes the various
forecasting periods, regimes, and the authors’ opinions on the preferred methodologies.

16. Exchange Rate Dynamics. 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 9.9 in the
text, is S0. The U.S. Federal Reserve announces an expansionary monetary policy that 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 that 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 toward 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.

17. Foreign Currency Speculation. 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

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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.

18. Cross-Rate Consistency in Forecasting. 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.

19. Stabilizing Versus Destabilizing Expectations. Define stabilizing and destabilizing expectations,
and describe how they play a role in the long-term determination of exchange rates.

If market participants have stabilizing expectations, when forces drive the currency’s value below the
long-term fundamental equilibrium path, they will buy the currency driving its value back toward the
fundamental equilibrium path. If market participants have destabilizing expectations and forces drive
the currency’s value away from the fundamental path, participants may not move immediately or in
significant volume to push the currency’s value back toward the fundamental equilibrium path for an
extended period of time (or possibly establish a new long-term fundamental path).

20. Currency Forecasting Services. Many multinational firms use forecasting services regularly. If
forecasting is essentially “foretelling the future,” and that is theoretically impossible, why would
these firms spend money on these services?

If nothing else, a variety of opinions is generally useful when attempting to predict the future. Most
forecasting services also provide added discipline to the forecasting process often missing within
smaller corporate finance units. For example, the need to focus on the likely movement of an
exchange rate within a specific time interval is typically stressed within a forecasting unit while not
within a business unit’s planning horizon. A treasurer might also 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.”

© 2016 Pearson Education, Inc.
CHAPTER 10
TRANSACTION EXPOSURE

1. Foreign Exchange Exposure. Define the three types of foreign exchange exposure.

The three main types of foreign exchange exposure are transaction, translation, and operating:

Transaction exposure measures changes in the value of outstanding financial obligations incurred
prior to a change in exchange rates but not due to be settled until after the exchange rates change.
Thus, it deals with changes in cash flows that result from existing contractual obligations.

Translation exposure is the potential for accounting-derived changes in owner’s equity to occur
because of the need to “translate” foreign currency financial statements of foreign subsidiaries
into a single reporting currency to prepare worldwide consolidated financial statements.

Operating exposure, also called economic exposure, competitive exposure, or strategic exposure,
measures the change in the present value of the firm resulting from any change in future operating
cash flows of the firm caused by an unexpected change in exchange rates. The change in value
depends on the effect of the exchange rate change on future sales volume, prices, and costs.

2. Currency Exposure and Contracting. Which of the three currency exposures relate to cash flows
already contracted for, and which of the exposures do not?

Transaction exposures are existing exposures of the firm, resulting from identifiable transaction.
Operating exposures are exposures that are likely—anticipated—but not yet existing or contracted.

3. Currency Risk. Define currency risk.

Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes.

4. Hedging. What is a hedge? How does that differ from speculation?

A hedge is the acquisition of a contract or a physical asset that will offset a change in value of some
other contract or physical asset. Hedges are entered into to reduce or eliminate risk, as opposed to
speculation, which is the taking of a position for the purposes of potential profit.

5. Value of the Firm. What—according to financial theory—is the value of a firm?

According to financial theory, the value of a firm is the net present value of all expected future cash
flows.

6. Cash Flow Variability. How does currency hedging theoretically change the expected cash flows of
the firm?

Hedging reduces the variability of expected cash flows. In some cases hedging may also bound or
limit the variability of expected cash flows on an absolute basis.

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7. Arguments for Currency Hedging. Describe four arguments in favor of a firm pursuing an active
currency risk management program?

1. Reduction in risk of future cash flows improves the planning capability of the firm. If the firm can
more accurately predict future cash flows, it may be able to undertake specific investments or
activities that it might otherwise not consider.

2. Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall
below a level sufficient to make debt-service payments in order for it to continue to operate. This
minimum cash flow point, often referred to as the point of financial distress, lies left of the center
of the distribution of expected cash flows. Hedging reduces the likelihood of the firm’s cash
flows falling to this level.

3. Management has a comparative advantage over the individual shareholder in knowing the actual
currency risk of the firm. Regardless of the level of disclosure provided by the firm to the public,
management always possesses an advantage in the depth and breadth of knowledge concerning
the real risks.

4. Markets are usually in disequilibrium because of structural and institutional imperfections, as
well as unexpected external shocks (such as an oil crisis or war). Management is in a better
position than shareholders are to recognize disequilibrium conditions and to take advantage of
opportunities to enhance firm value through selective hedging (the hedging of exceptional
exposures or the occasional use of hedging when management has a definite expectation of the
direction of rates).

8. Arguments Against Currency Hedging. Describe six arguments against a firm pursuing an active
currency risk management program?

1. Shareholders are more capable of diversifying currency risk than the management of the firm are.
If stockholders do not wish to accept the currency risk of any specific firm, they can diversify
their portfolios to manage the risk in a way that satisfies their individual preferences and risk
tolerance.

2. Currency risk management does not increase the expected cash flows of the firm. Currency risk
management does, however, consume firm resources and so reduces cash flow. The impact on
value is a combination of the reduction of cash flow (which lowers value) and the reduction in
variance (which increases value).

3. Management often conducts hedging activities that benefit management at the expense of the
shareholders. The field of finance called agency theory frequently argues that management is
generally more risk-averse than shareholders are.

4. Managers cannot outguess the market. If and when markets are in equilibrium with respect to
parity conditions, the expected net present value of hedging should be zero.

5. Management’s motivation to reduce variability is sometimes driven by accounting reasons.
Management may believe that it will be criticized more severely for incurring foreign exchange
losses than for incurring similar or even higher cash costs in avoiding the foreign exchange loss.
Foreign exchange losses appear in the income statement as a highly visible separate line item or
as a footnote, but the higher costs of protection are buried in operating or interest expenses.

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6. Efficient market theorists believe that investors can see through the “accounting veil” and
therefore have already factored the foreign exchange effect into a firm’s market valuation.
Hedging would only add cost.

9. Transaction Exposure. What are the four main types of transactions from which transaction
exposure arises?

Transaction exposure measures gains or losses that arise from the settlement of existing financial
obligations whose terms are stated in a foreign currency. Transaction exposure arises from any of the
following:

1. Purchasing or selling on credit, on open account, goods or services when prices are stated in
foreign currencies
2. Borrowing or lending funds when repayment is to be made in a foreign currency
3. Being a party to an unperformed foreign exchange forward contract
4. Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

10. Life Span of a Transaction Exposure. Diagram the life span of an exposure arising from selling a
product on open account. On the diagram define and show quotation, backlog, and billing exposures.

See chapter Exhibit 10.3 for the entire life span.

11. Unperformed Contracts. Which contract is more likely not to be performed: a payment due from a
customer in foreign currency (a currency exposure) or a forward contract with a bank to exchange the
foreign currency for the firm’s domestic currency at a contracted rate (the currency hedge)?

The forward contract agreement with a financial service provider—a bank—is much more “certain”
than is the receipt of cash in payment on an outstanding receivable.

12. Cash Balances. Why do foreign currency cash balances not cause transaction exposure?

A transaction exposure is defined as a foreign currency denominated cash flow occurring at a future
date in time. Because cash balances are in the present, not a future cash flow, they are not defined as
transaction exposures.

13. Contractual Currency Hedges. What are the four main contractual instruments used to hedge
transaction exposure?

The four main contractual instruments or hedges used to hedge transaction exposure are foreign
currency forwards, foreign currency futures, money market derivatives, and foreign currency options.

14. Money Market Hedges. How does a money market hedge differ for an account receivable versus
that of an account payable? Is it really a meaningful difference?

A money market hedge for an account receivable is the use of the A/R as collateral against a foreign
currency loan (the A/R is not being sold, only posted as collateral for a loan). This creates a short-
term loan or debt obligation on the hedger’s balance sheet that “matches” the foreign currency
receivable.

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A money market hedge for an account payable requires the company to exchange money now to be
placed on deposit in a foreign currency financial account in an amount which, upon maturity, will
satisfy the account payable in full.

Whether there is a meaningful difference between the two is debatable and somewhat situational. A
heavily indebted firm will not find taking on additional debt obligations (hedging the A/R) because
that will increase all debt-based financial metrics and ratios. A firm that does not enjoy ready access
to affordable capital will find the foreign currency deposit (hedging the A/P) difficult, as it means
putting scarce capital into an account for earning nothing but interest when capital is hard to come by.

15. Balance Sheet Hedging. What is the difference between a balance sheet hedge, a financing hedge,
and a money market hedge?

A balance sheet hedge is any foreign currency denominated asset or liability created to offset a
similar foreign currency denominated liability or asset.

A financing or financial hedge is any financial position, a deposit or loan obligation, created to
offset a matching foreign currency denominated exposure.

A money market hedge is one type of financial hedge, where a foreign currency loan is acquired
to hedge a foreign currency denominated account receivable, or a foreign currency deposit is
created to hedge a foreign currency denominated account payable.

16. Forward versus Money Market Hedging. Theoretically, shouldn’t forward contract hedges and
money market hedges have the same identical outcome? Don’t they both use the same three specific
inputs—the initial spot rate, the domestic cost of funds, and the foreign cost of funds?

On a theoretical basis, both structures do indeed include the same three basic components. What
differs, however, is the rates of interest utilized in constructing the positions. The forward contract
uses eurocurrency deposit rates (effectively the same as LIBOR rates) in the construction of the
forward rate.

The money market hedge, however, uses a deposit rate (for an A/P) or a borrowing rates (for an A/R)
for the execution of the structure. Borrowing rates will include the lender’s credit assessment of the
borrower. In both cases, the firm’s weighted average cost of capital, which will obviously differ
across firms, is needed for the estimation of the time value of money either used or accessed as part of
the money market hedge.

17. Foreign Currency Option Premia. Why do many firms object to paying for foreign currency option
hedges? Do firms pay for forward contract hedges? How do forwards and options differ if at all?

Consider the traditional alternative to the option—the forward contract. A firm does not exchange any
cash flow up-front for a forward. It does, however, have its available line of credit with the financial
institution reduced by the amount of the forward, but that is not an out-of-pocket cash obligation.

An option, however, is purchased—the option premium—and that is an explicit cost of acquiring the
derivative whether it is used or not in the end. (Option premiums are not necessarily settled up-front,
as many banks will simply combine the option premium settlement with the regular clearing of the
firm’s settlements with the bank, or combine it with the final settlement on the over-the-counter
option at option maturity.)

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Option premiums may also be significant in size. If a firm is purchasing a number of large options,
this may require a larger amount of capital than the firm has budgeted for treasury and currency
operations. Many firms simply object to spending money, option premiums, for a risk product that
may or may not be ultimately used.

18. Decision Criteria. Ultimately, a treasurer must choose among alternative strategies to manage
transaction exposure. Explain the two main decision criteria that must be used.

A treasurer must select based on two decision criteria: (1) the risk tolerance of the firm, as expressed
in its stated policies; and (2) the treasurer’s own view, or expectation of the direction (and distance)
the exchange rate will move over the exposure period.

19. Risk Management Hedging Practices. According to surveys of corporate practices, which currency
exposures do most firms regularly hedge?

Transaction exposures, once booked (recorded on the financial statements as an account receivable or
payable), are the most frequently hedged exposure. Conservative hedging policies dictate that
contractual hedges be placed only on existing exposures.

20. Hedge Ratio. What is the hedge ratio? Why would the hedge ratio ever be less than one?

The hedge ratio is basically what proportion or percentage of the total expected currency exposure is
hedged by the firm. Many firms regularly hedge 80% or 90% of their expected exposures as a
precaution of not receiving the total amount expected (as is often the case when firms deduct
penalties or fees associated with sale or payment settlement).

© 2016 Pearson Education, Inc.
CHAPTER 11
TRANSLATION EXPOSURE

1. Translation. What does the word translation mean? Why is translation exposure called an
accounting exposure?

Translation exposure arises because financial statements of foreign subsidiaries—which are stated in
foreign currency—must be restated in the parent’s reporting currency for the firm to prepare
consolidated financial statements.

Because translation occurs as a result of the accounting process, the restatement is most often called
“accounting.” Because exchange rates change from one period to another, imbalances occur. These
imbalances may cause an accounting-derived gain or loss, which is taken into the equity section of the
parent’s consolidated statement. The possibility of gain or loss gives rise to the word “exposure.”

2. Causation. What activity gives rise to translation exposure?

Consolidation of financial results for a multinational company. Although the exposure arises for all
firms with foreign subsidiaries, publicly traded firms, which report consolidated financial results
regularly, are thought to be “exposed” in terms of potential market reactions to changes in their
consolidated results arising from translation.

3. Converting Financial Assets. In the context of preparing consolidated financial statements, are the
words translate and convert synonyms?

They are not synonyms. To translate is to express the value of a financial account (assets, liability,
revenue, or expense) originally measured in one currency in another currency. Translation is pure
measurement; no transaction is involved.

To convert is to engage in a transaction in which an asset or liability originally measured in one
currency is physically exchanged for as asset or liability measured in another currency. Exchanging
pounds sterling for dollars in the foreign exchange market is converting sterling into dollars.
Swapping yen-denominated debt for dollar-denominated debt is converting the debt from once
currency to another.

4. Subsidiary Characterization. What is the difference between a self-sustaining foreign subsidiary
and an integrated foreign subsidiary?

An integrated foreign entity is one that operates as an extension of the parent company, with cash
flows and general business lines that are highly interrelated with those of the parent. A self-sustaining
foreign entity is one that operates in the local economic environment independent of the parent
company. The differentiation is important to the logic of translation. A foreign subsidiary should be
valued principally in terms of the currency that is the basis of its economic viability.

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5. Functional Currency. What is a functional currency? What do you think a “non-functional
currency” would be?

A foreign subsidiary’s functional currency is the currency of the primary economic environment in
which the subsidiary operates and in which it generates cash flows. In other words, it is the dominant
currency used by that foreign subsidiary in its day-to-day operations.

6. Functional Currency Designation. Can or should a company change the functional currency
designation of a foreign subsidiary from year to year? If so, when would it be justified?

The functional currency of an individual foreign subsidiary will rarely change on a year-to-year basis.
Because the functional currency designation arises from the fundamental economic principles of the
subsidiary’s business, this will not change frequently and is justified only when the dominant
currency of its operations changes.

7. Translation Methods. What are the two basic methods for translation used globally?

Two basic methods for translation are employed worldwide: the current rate method and the temporal
method. Regardless of which method is employed, a translation method must not only designate at
what exchange rate individual balance sheet and income statement items are remeasured, but also
designate where any imbalance is to be recorded, either in current income or in an equity reserve
account in the balance sheet.

8. Current versus Historical. One of the major differences between translation methods is which
balance sheet components are translated at which exchange rates, current or historical. Why would
accounting practices ever use historical exchange rates?

Equity investments in subsidiaries (initially and when added equity investments are made using
retained earnings) are generally recorded at the exchange rates in effect on their execution. This is
based on establishing the “cost basis” of those investments.

9. Translating Assets. What are the major differences in translating assets between the current rate
method and the temporal method?

Under the current rate method, all assets are translated at the current period (end of period) exchange
rate. Under the temporal method, inventories and fixed assets are translated at the exchange rate in
effect at the time of their acquisition/creation.

10. Translating Liabilities. What are the major differences in translating liabilities between the current
rate method and the temporal method?

Under both the current rate and temporal methods, all liabilities are translated or remeasured using the
current rate, while all equity account entries are translated at historical rates.

11. Earnings or Equity. Where do you believe that most company’s would prefer currency translation
imbalances or adjustments to go, to earnings or consolidated equity? Why?

Publicly traded companies are highly sensitive to changes in consolidated earnings. Earnings,
earnings per share, and changes in earnings per share are known to be extremely important to market
assessment of firm performance. Therefore, if the firm were publicly traded and had a choice as to

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where currency translation adjustments were to go, it would generally prefer consolidated equity, an
item of significantly lower market inspection.

12. Translation Exposure Management. What are the primary options firms have to manage
translation exposure?

The main technique to minimize translation exposure is called a balance sheet hedge. A balance sheet
hedge requires an equal amount of exposed foreign currency assets and liabilities on a firm’s
consolidated balance sheet. If this can be achieved for each foreign currency, net translation exposure
will be zero.

Some firms have attempted to hedge translation exposure in the forward market—with forward
contracts. Such action amounts to speculating in the forward market in the hope that a cash profit will
be realized to offset the noncash loss from translation. Success depends on a precise prediction of
future exchange rates, for such a hedge will not work over a range of possible future spot rates. In
addition, the profit from the forward “hedge” (i.e., speculation) is taxable, but the translation loss
does not reduce taxable income.

13. Accounting or Cash Flow. If a U.S.-based multinational company generates more than 80% of its
profits (earnings) outside the U.S. in the euro zone and Japan, and both the euro and the yen fall
significantly in value versus the dollar as occurred in the second half of 2014, is the impact on the
firm only accounting or does it alter cash flow, or both?

The impact would clearly be accounting at a minimum. Because consolidated income (earnings
reported to Wall Street) is formed by consolidating earnings from all affiliates from all over the
world, consolidated earnings would in this case be significantly reduced by translation. Corporate
cash flows may be reduced as well if the company remits some portion of its foreign earnings back to
the U.S. parent.

14. Balance Sheet Hedge Justification. When is a balance sheet hedge justified?

If a firm’s subsidiary is using the local currency as the functional currency, the following
circumstances could justify when to use a balance sheet hedge:

The foreign subsidiary is about to be liquidated, so that value of its CTA would be realized.
The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be
maintained within specific limits.
Management is evaluated based on certain income statement and balance sheet measures that are
affected by translation losses or gains.
The foreign subsidiary is operating in a hyperinflationary environment.

If a firm is using the parent’s home currency as the functional currency of the foreign subsidiary, all
transaction gains/losses are passed through to the income statement. Hedging this consolidated
income to reduce its variability may be important to investors and bond rating agencies.

15. Realization and Recognition. When would a multinational firm, if ever, realize and recognize the
cumulative translation losses recorded over time associated with a subsidiary?

A U.S.-based multinational firm will realize and recognize in current income the cumulative
translation gains and losses associated with an individual foreign affiliate when that affiliate is sold or
closed. Also, if a foreign affiliate is operating in an economic environment which experiences a

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cumulative rate of inflation of 100% or greater over a three-year period, it must use the temporal
method of translation and recognize and realize translation gains or losses in consolidated income in
the current period.

16. Tax Obligations. How does translation alter the global tax liabilities of a firm? If a multinational
firm’s consolidated earnings increase as a result of consolidation and translation, what is the impact
on tax liabilities?

This is in effect a trick question. Translation does not alter taxable income. Multinational companies
do not pay taxes on a consolidated basis. They pay taxes in the legal and jurisdictional countries in
which they operate, and in the case of the United States, on earnings from abroad when repatriated to
the parent company. Consolidation and translation alter none of these.

17. Hyperinflation. What is hyperinflation, and what are the consequences for translating foreign
financial statements in countries experiencing hyperinflation?

Hyperinflation is, by definition, a “very high and rapid monetary inflation, or the period during which
this occurs” (Encarta World English Dictionary). The prefix, hyper, means “over, beyond, over
much, above measure” (The Shorter Oxford English Dictionary on Historical Principles). In the
context of practical international accounting for multinational companies, hyperinflation is deemed to
exist when accumulated inflation is 100% or more over a three-year period.

18. Transaction versus Translation Losses. What are the main differences between losses from
transaction exposure and translation exposure?

Losses from transaction exposure are cash losses incurred in the near term because of a change in the
amount of cash to be received or paid on account of already-existing receivables or payables. The
focus is on a loss from an already-existing balance sheet account. These are “realized” losses and
therefore can be deducted from income for tax purposes.

Losses from translation exposure are changes in the size of the equity section of a parent company
issuing consolidated financial statements that result from a change in how foreign subsidiary financial
statements are measured for translation purposes. As such, losses from translation exposure are not
cash losses. The focus is on translation (“remeasurement, if you prefer) of both balance sheet and
income statement accounts.

© 2016 Pearson Education, Inc.
CHAPTER 12
OPERATING EXPOSURE

1. Exposure Definitions. Define operating exposure, economic exposure, and competitive exposure.
Can you provide any insights into what may be behind the use of the different terms?

All are names for the same exposure. If they are different, it must be only in a subtlety of meaning by
the user. Operating exposure, also referred to as economic exposure, competitive exposure, or
strategic exposure, measures any change in the present value of a firm resulting from changes in
future operating cash flows caused by any unexpected change in exchange rates. Economic exposure
emphasizes that the exposure is created by the economic consequences of an unexpected exchange
rate change. Economic consequences, in turn, suggests that the impact is due to the response of
external forces in the economy, rather than, say, something directly under the control of management.
Competitive exposure suggests that the consequences of an unexpected exchange rate change are due
to a shift in the competitive position of a firm, vis-á-vis its competitors.

2. Operating Exposure versus Translation Exposure. What do you see as the primary difference
between operating exposure and translation exposure? Would this have the same meaning to a private
firm as a publicly traded firm?

Operating exposure is far more important for the long-run health of a business than changes caused
by transaction or translation exposure. However, operating exposure is inevitably subjective because
it depends on estimates of future cash flow changes over an arbitrary time horizon. Thus, it does not
spring from the accounting process but rather from operating analysis. Planning for operating
exposure is a total management responsibility depending upon the interaction of strategies in finance,
marketing, purchasing, and production.

3. Unexpected Exchange Rate Changes. Why do unexpected exchange rate changes contribute to
operating exposure, but expected exchange rate changes do not?

Expected changes in foreign exchange rates should be incorporated in all financial plans of an MNE,
including both operating and financial budgets. Hence, the arrival of an expected exchange rate
change should not be a surprise requiring alteration of existing plans and procedures. Unexpected
exchange rate changes are those that could not have been anticipated or built into existing plans.
Hence, a reevaluation of existing plans and procedures must be considered.

One must note that because budgets are built around expected exchange rate changes, the unexpected
exchange rate is the deviation from the expected exchange rate, rather than the deviation from the
actual exchange rate at the time a budget was prepared.

4. Time Horizon. Explain the time horizons used to analyze and measure unexpected changes in
exchange rates.

Operating exposure is inevitably subjective because it depends on estimates of future cash flow
changes over an arbitrary time horizon. Thus, it does not spring from the accounting process but
rather from operating analysis. Planning for operating exposure is a total management responsibility
depending upon the interaction of strategies in finance, marketing, purchasing, and production.

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5. Static versus Dynamic. What are examples of static exposures versus dynamic exposures?

Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future
individual transaction exposures together with the future exposures of all the firm’s competitors and
potential competitors worldwide. Exchange rate changes in the short term affect current and
immediate contracts, generally termed transactions—static in nature. But over the longer term, as
prices change and competitors react, the more fundamental economic and competitive drivers of the
business may alter all cash flows of all units—dynamic in scope.

6. Operating versus Financing Cash Flows. According to financial theory, which is more important
to the value of the firm, financing or operating cash flows?

The cash flows of the MNE can be divided into operating cash flows and financing cash flows.
Operating cash flows arise from intercompany (between unrelated companies) and intracompany
(between units of the same company) receivables and payables, rent and lease payments for the use of
facilities and equipment, royalty and license fees for the use of technology and intellectual property,
and assorted management fees for services provided. These are the cash flows associated with the
conduct of business—and therefore are the source of value. Financing cash flows, such as the cash
flows associated with debt and equity, are according to financial theory not associated with value and
therefore of only secondary importance.

7. Macroeconomic Uncertainty. Explain how the concept of macroeconomic uncertainty expands the
scope of analyzing operating exposure.

Macroeconomic uncertainty is the sensitivity of the firm’s future cash flows to macroeconomic
variables in addition to foreign exchange, such as changes in interest rates and inflation rates.

8. Strategic Response. The objective of both operating and transaction exposure management is to
anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash
flows. What strategic alternative policies exist to enable management to manage these exposures?

The key to effective preparations for an unexpected devaluation is anticipation. Major changes to
protect a firm after an unexpected devaluation are minimally effective. Possibilities include
diversifying operations and diversifying financing.

9. Managing Operating Exposure. The key to managing operating exposure at the strategic level is for
management to recognize a disequilibrium in parity conditions when it occurs and to be pre-
positioned to react most appropriately. How can this task best be accomplished?

If a firm’s operations are diversified internationally, management is pre-positioned both to recognize
disequilibrium when it occurs and to react competitively. Consider the case where purchasing power
parity is temporarily in disequilibrium. Although the disequilibrium may have been unpredictable,
management can often recognize its symptoms as soon as they occur. For example, management
might notice a change in comparative costs in the firm’s own plants located in different countries. It
might also observe changed profit margins or sales volume in one area compared to another,
depending on price and income elasticities of demand and competitors’ reactions.

Recognizing a temporary change in worldwide competitive conditions permits management to make
changes in operating strategies. Management might make marginal shifts in sourcing raw materials,
components, or finished products. If spare capacity exists, production runs can be lengthened in one

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country and reduced in another. The marketing effort can be strengthened in export markets where the
firm’s products have become more price competitive because of the disequilibrium condition.

10. Diversification. How can a multinational firm diversify operations? How can it diversify its
financing? Do you believe these are effective ways of managing operating exposure?

Worldwide diversification in effect prepositions a firm to make a quick response to any loss from
operating exposure. The firm’s own internal cost control system and the alertness of its foreign staff
should give the firm an edge in anticipating countries where the currency is weak. Recognizing a
weak currency is different from being able to predict the time or amount of a devaluation, but it does
allow some defensive planning.

If the firm is already diversified, it should be able to shift sourcing, production, or sales effort from
one country or currency to another in order to benefit from the change in the post-devaluation
economic situation. Such shifts could be marginal or major.

Unexpected devaluations change the cost of the several components of capital—in particular, the cost
of debt in one market relative to another. If a firm has already diversified its sources of financing, that
is, established itself as a known and reputable factor in several capital markets, it can quickly move to
take advantage of any temporary deviations from the international Fisher effect by changing the
country or currency where borrowings are made.

11. Proactive Management. Operating exposures can be partially managed by adopting operating or
financing policies that offset anticipated foreign exchange exposures. What are four of the most
commonly employed proactive policies?

The four most common proactive policies and a brief explanation are matching currency cash flows,
risk-sharing agreements, back-to-back loans, and currency swaps.

12. Matching Currency Exposure. Explain how matching currency cash flows can offset operating
exposure.

The essence of this approach is to create operating or financial foreign currency cash outflows to
match equivalent foreign currency inflows. Often debt is incurred in the same foreign currency in
which operating cash flows are received.

13. Risk Sharing. An alternative arrangement for managing operating exposure between firms with a
continuing buyer-supplier relationship is risk sharing. Explain how risk sharing works.

Contracts, including sales and purchasing contracts, between parties operating in different currency
areas can be written such that any gain or loss caused by a change in the exchange rate will be shared
by the two parties.

14. Back-to-Back Loans. Explain how back-to-back loans can hedge foreign exchange operating
exposure. Would firms have any specific worries about their partner in a back-to-back loan
arrangement?

Two firms in different countries lend their home currency to each other and agree to repay each other
the same amount at a later date. This can be viewed as a loan between two companies (independent
entities or subsidiaries in the same corporate family) with each participant both making a loan and
receiving 100% collateral in the other’s currency. A back-to-back loan appears as both a debt

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(liability side of the balance sheet) and an amount to be received (asset side of the balance sheet) on
the financial statements of each firm.

15. Currency Swaps. Explain how currency swaps can hedge foreign exchange operating exposure.
What are the accounting advantages of currency swaps?

In terms of financial flows, the currency swap is almost identical to the back-to-back loan. However,
in a currency swap, each participant gives some of its currency to the other participant and receives in
return an equivalent amount of the other participant’s currency. No debt or receivable shows on the
financial statements as this is in essence a foreign exchange transaction. The swap allows the
participants to use foreign currency operating inflows to unwind the swap at a later date.

16. Hedging the Unhedgeable. How do some firms attempt to hedge their long-term operation exposure
with contractual hedges? What assumptions do they make in order to justify contractual hedging of
their operating exposure? How effective is such contractual hedging in your opinion?

The ability of firms to hedge the “unhedgeable” depends on predictability: (1) the predictability of the
firm’s future cash flows and (2) the predictability of the firm’s competitor’s responses to exchange
rate changes. Although the management of many firms may believe they are capable of predicting
their own cash flows, in practice few feel capable of accurately predicting competitor response. Many
firms still find timely measurement of exposure challenging.

A significant question remains as to the true effectiveness of hedging operating exposure with
contractual hedges. The fact remains that even after feared exchange rate movements and put option
position payoffs have occurred, the firm is competitively disadvantaged. The capital outlay required
for the purchase of such sizeable put option positions is capital not used for the potential
diversification of operations, which in the long run might have more effectively maintained the firm’s
global market share and international competitiveness.

© 2016 Pearson Education, Inc.
CHAPTER 13
THE GLOBAL COST AND AVAILABILITY OF CAPITAL

1. Segmented Market. What are the most common challenges a firm resident in a segmented market
faces in regards to its access to capital?

An illiquid market is one in which it is difficult to buy or sell shares, and especially an abnormally
large number of shares, without a major change in price. From a company perspective, an illiquid
market is one in which it is difficult to raise new capital because there are insufficient buyers for a
reasonably sized offering. From an investor’s perspective, an illiquid market means that the investor
will have difficulty selling any shares owned without a major drop in price.

2. Dimensions of Capital. Global integration has given many firms access to new and cheaper sources
of funds beyond those available in their home markets. What are the dimensions of a strategy to
capture this lower cost and greater availability of capital?

Global integration of capital markets has given many firms access to new and cheaper sources of
funds beyond those available in their home markets. These firms can then accept more long-term
projects and invest more in capital improvements and expansion. If a firm resides in a country with
illiquid or segmented capital markets, it can achieve this lower global cost and greater availability of
capital by a properly designed and implemented strategy.

3. Cost of Capital Benefits. What are the benefits of achieving a lower cost and greater availability of
capital?

A firm can accept more long-term projects and invest more in capital improvements and expansion
because of the lower hurdle rate in capital budgeting and the lower marginal cost of capital as more
funds are raised.

4. Equity Cost and Risk. What are the classifications used in defining risk in the estimation of a firm’s
cost of equity?

Systematic risk. Systematic risk is the risk of share price changes that cannot be avoided by
diversification. In other words, it is the risk that the stock market as a whole will rise or fall, and the
price of shares of an individual company will rise and fall with the market. Systematic risk is
sometimes called market risk.

Beta (in the Capital Asset Pricing Model). Beta is a measure of the systematic risk of a firm, where
“systematic risk” means that risk that cannot be diversified away. Beta measures the amount of
fluctuation expected in a firm’s share price, relative to the stock market as a whole. Thus a beta of 0.8
would indicate an expectation that the share price of a given company would rise or fall at 80% of the
rise or fall in the stock market in general. The stock is expected to be less volatile than the market as a
whole. A beta of 1.6 would indicate an expectation that the share price of a given company would rise
or fall at 60% more that the rise or fall in the market. If the market rose, say, 20% during a year, a
stock with a beta of 1.6 would be expected to rise (0.20)(1.6) = 0.32, or 32%.

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5. Equity Risk Premiums. What is an equity risk premium? For an equity risk premium to be truly
useful, what need it do?

The equity risk premium is the average annual return of the market expected by investors over and
above riskless debt, the term (km – krf). To be useful, it must be a relatively accurate forecast of what
market returns will be in the near- to medium-term future.

6. Portfolio Investors. Both domestic and international portfolio managers are asset allocators. What is
their portfolio management objective?

Their objective is to maximize a portfolio’s rate of return for a given level of risk or to minimize risk
for a given rate of return. International portfolio managers can choose from a larger bundle of assets
than portfolio managers limited to domestic-only asset allocations.

7. International Portfolio Management. What is the main advantage that international portfolio
managers have compared to portfolio managers limited to domestic-only asset allocation?

Internationally diversified portfolios often have a higher expected rate of return, and they nearly
always have a lower level of portfolio risk because national securities markets are imperfectly
correlated with one another.

8. International CAPM. What are the fundamental distinctions that the international CAPM tries to
capture which traditional domestic CAPM does not?

In theory, the primary distinction in the estimation of the cost of equity for an individual firm using an
internationalized version of the CAPM is the definition of the “market” and a recalculation of the
firm’s beta for that market. International CAPM (ICAPM) assumes that there is a global market in
which the firm’s equity trades, and estimates of the firm’s beta (βjg) and the market risk premium
(kmg – krfg) must then reflect this global portfolio.

9. Dimensions of Asset Allocation. Portfolio asset allocation can be accomplished along many
dimensions depending on the investment objective of the portfolio manager. Identify the various
dimensions.

Portfolio asset allocation can be accomplished along many dimensions depending on the investment
objective of the portfolio manager. For example, portfolios can be diversified according to the type of
securities. They can be composed of stocks only, bonds only, or a combination of both. They also can
be diversified by industry or by size of capitalization (small-cap, mid-cap, and large-cap stock
portfolios).

10. Market Liquidity. What is meant by the term market liquidity? What are the main disadvantages for
a firm to be located in an illiquid market?

Although no consensus exists about the definition of market liquidity, we can observe market
liquidity by noting the degree to which a firm can issue a new security without depressing the existing
market price, as well as the degree to which a change in price of its securities elicits a substantial
order flow.

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11. Market Segmentation. What is market segmentation, and what are the six main causes of market
segmentation?

Capital market segmentation is a financial market imperfection caused mainly by government
constraints, institutional practices, and investor perceptions. The most important imperfections are the
following:
Asymmetric information between domestic and foreign-based investors
Lack of transparency
High securities transaction costs
Foreign exchange risks
Political risks
Corporate governance differences
Regulatory barriers

12. Market Liquidity. What is the effect of market liquidity and segmentation on a firm’s cost of
capital?

Firms located in an illiquid and segmented capital market will usually have a higher marginal cost of
capital.

13. Emerging Markets. Firms located in illiquid and segmented emerging markets would benefit from
nationalizing their own cost of capital. What do they need to do, and what conditions must exist for
their efforts to succeed?

Multinational firms based in emerging markets often face barriers and lack of visibility similar to
what Novo faced. They could benefit by following Novo’s proactive strategy employed to attract
international portfolio investors. However, a word of caution is advised. Novo had an excellent
operating track record and a very strong worldwide market niche in two important industry sectors,
insulin and industrial enzymes. This record continues to attract investors in Denmark and abroad.
Other companies would also need to have such a favorable track record to attract foreign investors.

14. Cost of Capital for MNEs. Do multinational firms have a higher or lower cost of capital than their
domestic counterparts? Is this surprising?

Theoretically, MNEs should be in a better position than their domestic counterparts to support higher
debt ratios because their cash flows are diversified internationally. However, recent empirical studies
have come to the opposite conclusion. These studies also concluded that MNEs have higher betas
than their domestic counterparts.

15. Multinational Use of Debt. Do multinational firms use relatively more or less debt than their
domestic counterparts? Why?

According to empirical studies, multinational firms appear to use less debt than their domestic
counterparts. We believe it results from a variety of factors. First, despite the favorable effect of
international diversification of cash flows, bankruptcy risk was only about the same for MNEs as for
domestic firms. However, MNEs faced higher agency costs, political risk, foreign exchange risk, and
asymmetric information. These have all been identified as the factors leading to lower debt ratios and

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even a higher cost of long-term debt for MNEs. Domestic firms rely much more heavily on short and
intermediate debt, which lie at the low cost end of the yield curve.

16. Multinationals and Beta. Do multinational firms have higher lower betas than their domestic
counterparts?

A number of studies have found that MNEs have a higher level of systematic risk than their domestic
counterparts. The same factors caused this phenomenon that caused the lower debt ratios for MNEs.
In general, the increased standard deviation of cash flows from internationalization more than offset
the lower correlation from diversification.

17. The “Riddle.” What is the riddle?

The riddle is an attempt to explain under what conditions an MNE would have a higher or lower debt
ratio and beta than its domestic counterpart does. The answer to this riddle lies in the link between the
cost of capital, its availability, and the opportunity set of projects. As the opportunity set of projects
increases, eventually the firm needs to increase its capital budget to the point where its marginal cost
of capital is increasing. The optimal capital budget would still be at the point where the rising
marginal cost of capital equals the declining rate of return on the opportunity set of projects.
However, this would be at a higher weighted average cost of capital than would have occurred for a
lower level of the optimal capital budget.

To illustrate this linkage, Exhibit 13.8 in the chapter shows the marginal cost of capital given
different optimal capital budgets. Assume that there are two different demand schedules based on the
opportunity set of projects for both the multinational enterprise (MNE) and domestic counterpart
(DC).

18. Emerging Market Listings. Why might emerging market multinationals list their shares abroad?

First, to improve liquidity and escape from a segmented home market.

Secondly, internationalization may actually allow emerging market MNEs to carry a higher level of
debt and lower their systematic risk. This may occur because the emerging market MNEs are
investing in more stable economies abroad, a strategy that lowers their operating, financial, foreign
exchange, and political risks. The reduction in risk more than offsets their increased agency costs and
allows the emerging market MNEs to enjoy higher leverage and lower systematic risk than their
U.S.–based MNE counterparts.

© 2016 Pearson Education, Inc.

CHAPTER 14
RAISING EQUITY AND DEBT GLOBALLY

1. Equity Sourcing Strategy. Why does the strategic path to sourcing equity start with debt?

Most firms should start sourcing abroad with an international bond issue to gain name recognition in
the global financial markets. This could be followed by an international bond issue in a target market
or in the eurobond market. The next step might be to cross-list and issue equity in one of the less
prestigious markets in order to attract the attention of international investors.

2. Optimal Financial Structure. If the cost of debt is less than the cost of equity, why doesn’t the
firm’s cost of capital continue to decrease with the use of more and more debt?

When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined
by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of
business risk. If the business risk of new projects differs from the risk of existing projects, the optimal
mix of debt and equity would change to recognize trade-offs between business and financial risks. As
more and more debt is taken on, the firm’s perceived ability to service those cash flow obligations
worsens and its riskiness rises as does its cost of equity.

3. Multinationals and Cash Flow Diversification. How does the multinational’s ability to diversify its
cash flows alter its ability to use greater amounts of debt?

Multinational firms are in a better position than domestic firms to support higher debt ratios because
their cash flows are diversified internationally. The probability of a firm covering fixed charges under
varying conditions in product, financial, and foreign exchange markets should increase if the
variability of its cash flows is minimized.

By diversifying cash flows internationally, the MNE might be able to achieve the same kind of
reduction in cash flow variability as portfolio investors receive from diversifying their security
holdings internationally. Returns are not perfectly correlated between countries. In contrast, a
domestic firm would not enjoy the benefit of international cash flow diversification. Instead, it would
need to rely entirely on its own net cash inflow from domestic operations.

4. Foreign Currency Denominated Debt. How does borrowing in a foreign currency change the risk
associated with debt?

Changes in foreign exchange rates caused the ex post cost of borrowing to increase or decrease from
what was originally expected. Management can only guess at future foreign exchange risk. Therefore,
they could either borrow only in their functional currency or diversify by currency their sources of
borrowing.

5. Three Keys to Global Equity. What are the three key elements related to raising equity capital in the
global marketplace?

Equity issuance, equity listing, and private placement.

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6. Global Equity Alternatives. What are the alternative structures available for raising equity capital on
the global market?

1. Sale of a directed public share issue to investors in a target market
2. Sale of a euroequity public issue to investors in more than one market, including both foreign and
domestic markets
3. Private placements under SEC Rule 144A
4. Sale of shares to private equity funds
5. Sale of shares to a foreign firm as part of a strategic alliance

7. Directed Public Issues. What is a directed public issue? What is the purpose of this kind of an
international equity issuance?

A directed public share issue is defined as one that is targeted at investors in a single country and
underwritten in whole or in part by investment institutions from that country. The issue might or
might not be denominated in the currency of the target market. The shares might or might not be
cross-listed on a stock exchange in the target market.

8. Depositary Receipts. What is a depositary receipt? What are equity shares listed and issued in
foreign equity markets in this form?

Depositary receipts (depositary shares) are negotiable certificates issued by a bank to represent the
underlying shares of stock, which are held in trust at a foreign custodian bank. American depositary
receipts (ADRs) are certificates traded in the United States and denominated in U.S. dollars. ADRs
are sold, registered, and transferred in the United States in the same manner as any share of stock,
with each ADR representing some multiple of the underlying foreign share.

9. GDRs, ADRs, and GRSs. What is the difference between a GDR, ADR, and GRS? How are these
differences significant?

Similar to ordinary shares, GDRs have the added benefit of being able to be traded on equity
exchanges around the globe in a variety of currencies. ADRs, however, are quoted only in U.S.
dollars and are traded only in the United States. GDRs can, theoretically, be traded with the sun,
following markets as they open and close around the globe around the clock. The shares are traded
electronically, thereby eliminating the specialized forms and depositaries required by share forms like
ADRs.

10. Sponsored and Unsponsored. ADRs and GDRs can be sponsored or unsponsored. What does it
mean and will it matter to the investors purchasing the shares?

Sponsored depositary receipts. Sponsored ADRs are created at the request of a foreign firm wanting
its shares traded in the United States. The firm applies to the Securities and Exchange Commission
(SEC) and a U.S. bank for registration and issuance of ADRs.

Unsponsored depositary receipts. If a foreign firm does not seek to have its shares traded in the
United States but U.S. investors are interested, a U.S. securities firm may initiate creation of the
ADRs. Such an ADR would be unsponsored, but the SEC still requires that all new ADR programs
must have approval of the firm itself even if it is not a sponsored ADR.

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11. ADR Levels. Distinguish between the three levels of commitment for ADRs traded in the United
States.

Level I (“over the counter” or pink sheets) is the easiest to satisfy. It facilitates trading in foreign
securities that have been acquired by U.S. investors but are not registered with the SEC. It is the least
costly approach but might have a minimal impact on liquidity. Level II applies to firms that want to
list existing shares on the NYSE, AMEX, or NASDAQ markets. They must meet the full registration
requirements of the SEC. This means reconciling their financial accounts with those used under U.S.
GAAP, which raises the cost considerably. Level III applies to the sale of a new equity issued in the
United States. It too requires full registration with the SEC and an elaborate stock prospectus. This is
the most expensive alternative but the most likely to improve the stock’s liquidity and escape from
home market segmentation.

12. IPOs and FOs. What is the significance of IPOs versus FOs?

An IPO, an initial public offering, is when a firm first raises capital by listing its shares in a public
market. The FO or follow-on offerings is when the company over time issues additional shares in the
public market in order to raise additional equity.

13. Foreign Equity Listing and Issuance. Give five reasons why a firm might cross-list and sell its
shares on a very liquid stock exchange.

1. Improve the liquidity of its existing shares and support a liquid secondary market for new equity
issues in foreign markets.
2. Increase its share price by overcoming mispricing in a segmented and illiquid home capital
market.
3. Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors, and
host governments.
4. Establish a secondary market for shares used to acquire other firms in the host market.
5. Create a secondary market for shares that can be used to compensate local management and
employees in foreign subsidiaries.

14. Cross-Listing Abroad. What are the main reasons causing firms to cross-list abroad?

A recent study of U.S. firms that issued equity abroad concluded that increased name recognition and
accessibility from global equity issues leads to increased investor recognition and participation in
both the primary and secondary markets. Moreover, the ability to issue global shares can validate firm
quality by reducing the information asymmetry between insiders and investors. Another conclusion
was that U.S. firms may seize a window of opportunity to switch to global offerings when domestic
demand for their shares is weak. Finally, the study found that U.S. firms announcing global equity
offerings have significantly less negative market reactions by about one percentage point than what
would have been expected had they limited their issues to the domestic market.

15. Barriers to Cross-Listing. What are the main barriers to cross-listing abroad?

A decision to cross-list must be balanced against the implied increased commitment to full disclosure
and a continuing investor relations program. For firms resident in the Anglo-American markets,
listing abroad might not appear to be much of a barrier. For example, the SEC’s disclosure rules for
listing in the United States are so stringent and costly that any other market’s rules are mere child’s

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play. Reversing the logic, however, non–U.S. firms must really think twice before cross-listing in the
United States. Not only are the disclosure requirements breathtaking, but a continuous timely
quarterly information is required by U.S. regulators and investors. As a result, the foreign firm must
provide a costly continuous investor relations program for its U.S. shareholders, including frequent
“road shows” and the time-consuming personal involvement of top management.

16. Private Placement. What is a private placement? What are the comparative pros and cons of private
placement versus a pubic issue?

A firm, public or private, can place an issue with private investors, a private placement. (Note that
private placement may refer to either equity or debt.) Private placements can take a variety of
different forms, and the intent of investors may be passive (e.g., Rule 144A investors) or active (e.g.,
private equity, where the investor intends to control and change the firm).

17. Private Equity. What is private equity, and how do private equity funds differ from traditional
venture capital firms?

Private equity funds are usually limited partnerships of institutional and wealthy individual investors
that raise their capital in the most liquid capital markets, especially the United States. They then
invest the private equity fund in mature, family-owned firms located in emerging markets. The
investment objective is to help these firms to restructure and modernize in order to face increasing
competition and the growth of new technologies.

Private equity funds differ from traditional venture capital funds. The latter usually operate mainly in
highly developed countries. They typically invest in high technology start-ups with the goal of exiting
the investment with an initial public offering (IPO) placed in those same highly liquid markets. Very
little venture capital is available in emerging markets, partly because it would be difficult to exit with
an IPO in an illiquid market. The same exiting problem faces the private equity funds, but they appear
to have a longer time horizon, they invest in already mature and profitable companies, and they are
content with growing companies through better management and mergers with other firms.

18. Bank Loans versus Securitized Debt. What is the advantage of securitized debt instruments sold on
a market versus bank borrowing for multinational corporations?

If a multinational firm is widely known in the global capital markets, it generally prefers to issue
securitized debt over the use of bank loans. Purchasers of eurobonds do not rely only on bond-rating
services or on detailed analyses of financial statements. The general reputation of the issuing
corporation and its underwriters has been a major factor in obtaining favorable terms. For this reason,
larger and better known MNEs, state enterprises, and sovereign governments are able to obtain the
lowest interest rates. Firms whose names are better known to the general public, possibly because
they manufacture consumer goods, are often believed to have an advantage over equally qualified
firms whose products are less widely known.

19. International Debt Instruments. What are the primary alternative instruments available for raising
debt on the international marketplace?

Syndicated loans. Syndication allows many different investors to “participate” in the funding of the
loan, thereby allowing them to diversify their risk or exposure to the individual borrower. The result
is the borrower gains access to a greater availability of capital at a lower cost of funds.

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Euronotes. A major development in international money markets was the establishment of facilities
for sales of short-term, negotiable, promissory notes—euronotes. Among the facilities for their
issuance were revolving underwriting facilities (rufs), note issuance facilities (nifs), and standby note
issuance facilities (snifs). These facilities were provided by international investment and commercial
banks. The euronote was a substantially cheaper source of short-term funds than syndicated loans
because the notes were placed directly with the investor public, and the securitized and underwritten
form allowed the ready establishment of liquid secondary markets. The banks received substantial
fees initially for their underwriting and placement services.

Euro-commercial paper. Euro-commercial paper (ECP), like commercial paper issued in domestic
markets around the world, is a short-term debt obligation of a corporation or bank. Maturities are
typically one, three, and six months. The paper is sold normally at a discount or occasionally with a
stated coupon. Although the market is capable of supporting issues in any major currency, more than
90% of issues outstanding are denominated in U.S. dollars.

Euro-medium term notes. The EMTN’s basic characteristics are similar to those of a bond, with
principal, maturity, and coupon structures and rates being comparable. The EMTN’s typical
maturities range from as little as nine months to a maximum of 10 years. Coupons are typically paid
semiannually, and coupon rates are comparable to similar bond issues. The EMTN does, however,
have three unique characteristics. First, the EMTN is a facility, allowing continuous issuance over a
period, unlike a bond issue, which is essentially sold all at once. Second, because EMTNs are sold
continuously, in order to make debt service (coupon redemption) manageable, coupons are paid on set
calendar dates regardless of the date of issuance. Finally, EMTNs are issued in relatively small
denominations, from $2 million to $5 million, making medium-term debt acquisition much more
flexible than the large minimums customarily needed in the international bond markets.

International bonds. The international bond market sports a rich array of innovative instruments
created by imaginative investment bankers who are unfettered by the usual controls and regulations
governing domestic capital markets. Indeed, the international bond market rivals the international
banking market in terms of the quantity and cost of funds provided to international borrowers. All
international bonds fall within two generic classifications, eurobonds and foreign bonds. The
distinction between categories is based on whether the borrower is a domestic or a foreign resident
and whether the issue is denominated in the local currency or a foreign currency.

20. Eurobond versus Foreign Bonds. What is the difference between a eurobond and a foreign bond,
and why do two types of international bonds exist?

All international bonds fall within two generic classifications, eurobonds and foreign bonds. The
distinction between categories is based on whether the borrower is a domestic or a foreign resident,
and whether the issue is denominated in the local currency or a foreign currency.

A eurobond is underwritten by an international syndicate of banks and other securities firms and
is sold exclusively in countries other than the country in whose currency the issue is denominated.
For example, a bond issued by a firm resident in the United States, denominated in U.S. dollars
but sold to investors in Europe and Japan (not to investors in the United States), would be a
eurobond.

A foreign bond is underwritten by a syndicate composed of members from a single country, sold
principally within that country, and denominated in the currency of that country. The issuer,
however, is from another country. A bond issued by a firm resident in Sweden, denominated in
dollars, and sold in the United States to U.S. investors by U.S. investment bankers, would be a

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foreign bond. Foreign bonds have nicknames: foreign bonds sold in the United States are
“Yankee bonds”; foreign bonds sold in the United Kingdom are “bulldogs.”

A firm can now issue equity underwritten and distributed in multiple foreign equity markets,
sometimes simultaneously with distribution in the domestic market. The same financial institutions
that had previously created an infrastructure for the euronote and eurobond markets (described in
detail in Chapter 16) were responsible for the euroequity market. The term “euro” does not imply that
the issuers or investors are located in Europe nor does it mean the shares are sold in the currency
“euro.” It is a generic term for international securities issues originating and being sold anywhere in
the world.

21. Funding Foreign Subsidiaries. What are the primary methods of funding foreign subsidiaries, and
how do host government concerns affect those choices?

In general, although a minimum amount of equity capital from the parent company is required,
multinationals often strive to minimize the amount of equity in foreign subsidiaries in order to limit
risks of losing that capital. Equity investment can take the form of either cash or real goods
(machinery, equipment, inventory, etc.).

Although debt is the preferable form of subsidiary financing, access to local host country debt is
limited in the early stages of a foreign subsidiary’s life. Without a history of proven operational
capability and debt service capability, the foreign subsidiary may need to acquire its debt from the
parent company or from unrelated parties with a parental guarantee (after operations have been
initiated). Once the operational and financial capabilities of the subsidiary have been established, it
may then actually enjoy preferred access to debt locally.

22. Local Norms. Should foreign subsidiaries of multinational firms conform to the capital structure
norms of the host country or to the norms of their parent’s country?

Main advantages of localization. The main advantages of a finance structure for foreign subsidiaries
that conforms to local debt norms are as follows:

A localized financial structure reduces criticism of foreign subsidiaries that have been operating
with too high a proportion of debt (judged by local standards), often resulting in the accusation
that they are not contributing a fair share of risk capital to the host country. At the other end of
the spectrum, a localized financial structure would improve the image of foreign subsidiaries that
have been operating with too little debt and thus appear to be insensitive to local monetary policy.

A localized financial structure helps management evaluate return on equity investment relative to
local competitors in the same industry. In economies where interest rates are relatively high as an
offset to inflation, the penalty paid reminds management of the need to consider price level
changes when evaluating investment performance.

In economies where interest rates are relatively high because of a scarcity of capital, and real
resources are fully utilized (full employment), the penalty paid for borrowing local funds reminds
management that unless return on assets is greater than the local price of capital—that is, negative
leverage—they are probably misallocating scarce domestic real resources such as land and labor.
This factor may not appear relevant to management decisions, but it will certainly be considered
by the host country in making decisions with respect to the firm.

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Main disadvantages of localization. The main disadvantages of localized financial structures are as
follows:

An MNE is expected to have a comparative advantage over local firms in overcoming
imperfections in national capital markets through better availability of capital and the ability to
diversify risk. Why should it throw away these important competitive advantages to conform to
local norms established in response to imperfect local capital markets, historical precedent, and
institutional constraints that do not apply to the MNE?

If each foreign subsidiary of an MNE localizes its financial structure, the resulting consolidated
balance sheet might show a financial structure that does not conform to any particular country’s
norm. The debt ratio would be a simple weighted average of the corresponding ratio of each
country in which the firm operates. This feature could increase perceived financial risk and thus
the cost of capital for the parent, but only if two additional conditions are present:

1. The consolidated debt ratio is pushed completely out of the discretionary range of acceptable
debt ratios in the flat area of the cost of capital curve, shown previously in Exhibit 16.1.

2. The MNE is unable to offset high debt in one foreign subsidiary with low debt in other
foreign or domestic subsidiaries at the same cost. If the International Fisher effect is working,
replacement of debt should be possible at an equal after-tax cost after adjusting for foreign
exchange risk. On the other hand, if market imperfections preclude this type of replacement,
the possibility exists that the overall cost of debt, and thus the cost of capital, could increase if
the MNE attempts to conform to local norms.

The debt ratio of a foreign subsidiary only cosmetic because lenders ultimately look to the parent
and its consolidated worldwide cash flow as the source of repayment. In many cases, debt of
subsidiaries must be guaranteed by the parent firm. Even if no formal guarantee exists, an implied
guarantee usually exists because almost no parent firm would dare to allow an affiliate to default
on a loan. If it did, repercussions would surely be felt with respect to the parent’s own financial
standing, with a resulting increase in its cost of capital.

23. Internal Financing of Foreign Subsidiaries. What is the difference between “internal” financing
and “external” financing for a subsidiary?

“Internal sourcing” means the funds come from related firms. “External sourcing” means the funds
come from unrelated firms or investors. Internal financing types include (1) funds from the parent
company, (2) funds from sister subsidiaries, and (3) subsidiary borrowing with parent guarantees.

24. External Financing of Foreign Subsidiaries. What are the primary alternatives for the external
financing of a foreign subsidiary?

External financing types include (1) borrowing from sources in the parent country, (2) borrowing
from sources outside the parent country, and (3) raising equity locally.

© 2016 Pearson Education, Inc.
CHAPTER 15
MULTINATIONAL TAX MANAGEMENT

1. Primary Objective. What is the primary objective of multinational tax planning?

The primary objective of multinational tax planning is to pay the lowest global effective tax rate.

2. Tax Morality. What is meant by the term “tax morality”? If for example, your company has a
subsidiary in Russia where some believe tax evasion is a fine art, should you comply with Russian tax
laws or violate the laws as do your local competitors?

The MNE faces not only a morass of foreign taxes but also an ethical question. In many countries,
taxpayers, corporate or individual, do not voluntarily comply with the tax laws. Smaller domestic
firms and individuals are the chief violators. The MNE must decide whether to follow a practice of
full disclosure to tax authorities or adopt the philosophy, “When in Rome, do as the Romans do.”
Given the local prominence of most foreign subsidiaries and the political sensitivity of their position,
most MNEs follow the full disclosure practice. Some firms, however, believe that their competitive
position would be eroded if they did not avoid taxes to the same extent as their domestic competitors.
There is obviously no prescriptive answer to the problem because business ethics are partly a function
of cultural heritage and historical development.

3. Tax Neutrality. What is tax neutrality? What is the difference between domestic neutrality and
foreign neutrality?

When a government decides to levy a tax, it must consider not only the potential revenue from the
tax, or how efficiently it can be collected, but also the effect the proposed tax can have on private
economic behavior. For example, the U.S. government’s policy on taxation of foreign-source income
does not have as single objective, the raising of revenue.

One way to view neutrality is to require that the burden of taxation on each dollar, euro, pound, or
yen of profit earned in home country operations by an MNE be equal to the burden of taxation on
each currency equivalent of profit earned by the same firm in its foreign operations. This is called
domestic neutrality. A second way to view neutrality is to require that the tax burden on each foreign
subsidiary of the firm be equal to the tax burden on its competitors in the same country. This is called
foreign neutrality. The latter policy is often supported by MNEs because it focuses more on the
competitiveness of the individual firm in individual country markets.

4. Worldwide versus Territorial. What is the difference between the worldwide and territorial
approaches to taxation?

The worldwide approach, also referred to as the residential or national approach, levies taxes on the
income earned by firms that are incorporated in the host country, regardless of where the income was
earned (domestically or abroad). An MNE earning income both at home and abroad would therefore
find its worldwide income taxed by its home country tax authorities. For example, a country like the
United States taxes the income earned by firms based in the United States regardless of whether the
income earned by the firm is domestic or foreign in origin. In the case of the United States, ordinary
foreign-sourced income is taxed only as remitted to the parent firm. As with all questions of tax,
however, numerous conditions and exceptions exist. The primary problem is that this approach does

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not address the income earned by foreign firms operating within the United States. Countries like the
United States then apply the principle of territorial taxation to foreign firms within their legal
jurisdiction, taxing all income earned by foreign firms in their borders as well.

The territorial approach, also termed the source approach, focuses on the income earned by firms
within the legal jurisdiction of the host country, not on the country of firm incorporation. Countries
like Germany that follow the territorial approach apply taxes equally to foreign or domestic firms on
income earned within the country, but in principle not on income earned outside the country. The
territorial approach, like the worldwide approach, results in a major gap in coverage if resident firms
earn income outside the country but are not taxed by the country in which the profits are earned. In
this case, tax authorities extend tax coverage to income earned abroad if it is not currently covered by
foreign tax jurisdictions. Once again, a mix of the two tax approaches is necessary for full coverage of
income.

5. Direct or Indirect. What is the difference between a direct tax and an indirect tax?

Taxes are classified on whether they are applied directly to income, called direct taxes, or to some
other measurable performance characteristic of the firm, called indirect taxes.

6. Tax Deferral. What is meant by tax deferral in the U.S. system of taxation? What is the deferral
privilege?

If the worldwide approach to international taxation were followed to the letter, it would end the tax-
deferral privilege for many MNEs. Foreign subsidiaries of MNEs pay host country corporate income
taxes, but many parent countries defer claiming additional income taxes on that foreign-source
income until it is remitted to the parent firm.

For example, U.S. corporate income taxes on some types of foreign-source income of U.S.-owned
subsidiaries incorporated abroad are deferred until the earnings are remitted to the U.S. parent.
However, the ability to defer corporate income taxes is highly restricted and has been the subject of
many tax law changes in the past three decades.

7. Value-Added Tax. What is a value-added tax, and how does it differ from an income tax?

The value added tax is in effect a sales tax on the value added at every step of the production and
distribution process, adjusted so that the tax is not cumulative; i.e., a later stage of production does
not pay tax on taxes already levied at earlier stages.

The advantages of the value-added tax include (1) it is probably more neutral in its effect on
economic decisions, (2) the populace is generally more aware that they are paying the tax, and (3) it
can be rebated in the case of exports. The latter “advantage” puts countries using the value-added tax
at an advantage over those that rely on income taxes on the profit from exports because income taxes
cannot be rebated.

8. Withholding Tax. What is a withholding tax, and why do governments impose them?

Withholding taxes are a minimum tax payment due government prior to remittance, in this case,
outside the country. The reason for the institution of withholding taxes is that governments recognize
that most international investors will not file a tax return in each country in which they invest. The
government, therefore, wishes to ensure that a minimum tax payment is received. As the term
“withholding” implies, taxes are withheld by the corporation from the payment made to the investor,

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and the taxes withheld are then turned over to government authorities. Withholding taxes are a major
subject of bilateral tax treaties and generally range between 0% and 25%.

9. Tax Treaty. What is usually included within a tax treaty?

Tax treaties normally define whether taxes are to be imposed on income earned in one country by the
nationals of another, and if so, how. Tax treaties are bilateral, with the two signatories specifying
what rates are applicable to which types of income between the two countries alone.

The individual bilateral tax jurisdictions as specified through tax treaties are particularly important for
firms that are primarily exporting to another country rather than doing business there through a
“permanent establishment.” The latter would be the case for manufacturing operations. A firm that
only exports would not want any of its other worldwide income taxed by the importing country. Tax
treaties define what is a “permanent establishment” and what constitutes a limited presence for tax
purposes.

Tax treaties typically result in reduced withholding tax rates between the two signatory countries, the
negotiation of the treaty itself serving as a forum for opening and expanding business relationships
between the two countries. This practice is important both to MNEs operating through foreign
subsidiaries, earning active income, and to individual portfolio investors who are simply receiving
passive income in the form of dividends, interest, or royalties.

10. Active versus Passive. What do the terms active and passive mean in the context of U.S. taxation of
foreign source income?

Active income, the income arising from manufacturing or provision of services, is difficult to shift
across borders by ownership. Passive income, however, is more easily shifted and therefore may gain
undue deferral of U.S. taxation. Subpart F income is active income, subject to immediate U.S.
taxation even when not remitted, and is otherwise easily shifted offshore to avoid current taxation. It
includes (1) passive income received by the foreign corporation such as dividends, interest, rents,
royalties, net foreign currency gains, net commodities gains, and income from the sale of non-
income-producing property, (2) income from the insurance of U.S. risks, (3) financial service income,
(4) shipping income, (5) oil-related income, and (6) certain related-party sales and service income.

One type of passive income would simply be the distributed profits of another company, dividends, if
the foreign company owned it. Without the differential treatment, it would only make sense for most
U.S. multinationals to create a holding company in a tax haven, which would then own all the foreign
subsidiaries of the company. Then, all the profits earned by the holding company would be retained in
low tax environment without incurring any U.S. tax liabilities. An undesired outcome by the U.S. tax
authorities!

11. Tax Types. Taxes are classified based on whether they are applied directly to income, called direct
taxes, or to some other measurable performance characteristic of the firm, called indirect taxes.
Identify each of the following as a “direct tax,” an “indirect tax,” or something else:
a. Corporate income tax paid by a Japanese subsidiary on its operating income—Direct tax
b. Royalties paid to Saudi Arabia for oil extracted and shipped to world markets—Technically not a
tax, but in fact similar to a direct tax.
c. Interest received by a U.S. parent on bank deposits held in London—Any tax on such interest
would be a direct tax.

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d. Interest received by a U.S. parent on a loan to a subsidiary in Mexico—Direct tax
e. Principal repayment received by U.S. parent from Belgium on a loan to a wholly owned
subsidiary in Belgium—Not a tax
f. Excise tax paid on cigarettes manufactured and sold within the United States—Indirect tax
g. Property taxes paid on the corporate headquarters building in Seattle—Indirect tax
h. A direct contribution to the International Committee of the Red Cross for refugee relief—Not a
tax
i. Deferred income tax, shown as a deduction on the U.S. parent’s consolidated income tax—Direct
tax
j. Withholding taxes withheld by Germany on dividends paid to a United Kingdom parent
corporation—Direct tax

12. Foreign Tax Credit. What is a foreign tax credit? Why do countries give credit for taxes paid on
foreign source income?

To prevent double taxation of the same income, most countries grant a foreign tax credit for income
taxes paid to the host country. Countries differ on how they calculate the foreign tax credit and what
kinds of limitations they place on the total amount claimed. Normally foreign tax credits are also
available for withholding taxes paid to other countries on dividends, royalties, interest, and other
income remitted to the parent. The value-added tax and other sales taxes are not eligible for a foreign
tax credit but are typically deductible from pretax income as an expense.

A tax credit is a direct reduction of taxes that would otherwise be due and payable. It differs from a
deductible expense, which is an expense the taxpayer uses to reduce taxable income before the tax
rate is applied. A $100 tax credit reduces taxes payable by the full $100, whereas a $100 deductible
expense reduces taxable income by $100 and taxes payable by $100 × t, where t is the tax rate. Tax
credits are more valuable on a dollar-for-dollar basis than are deductible expenses.

13. Earnings Stripping. What is earnings stripping, and what are some examples of how multinational
firms pursue it?

A multinational firm may allocate debt differently across its various foreign subsidiaries to reduce tax
liabilities in high tax environments. Units in high tax environments may be assigned very high debt
obligations in an attempt to maximize the interest deductibility provisions offered in that country.
Often termed earnings stripping, this method is typically limited by host government requirements
for minimum equity capitalizations—thin capitalization rules.

14. Controlled Foreign Corporation. What is a controlled foreign corporation and what is its
significance in global tax management?

A controlled foreign corporation (CFC) is any foreign corporation in which U.S. shareholders,
including corporate parents, own more than 50% of the combined voting power or total value. Its
significance in global tax management arises from the fundamental assumption by U.S. tax authorities
that all income earned by a CFC is under the full control of the U.S. parent company, and any choice
to delay repatriation of passive income is made only to gain deferral of U.S. taxation.

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15. Transfer Pricing. What is a transfer price and can a government regulate it? What difficulties and
motives does a parent multinational firm face in setting transfer prices?

A transfer price is the amount paid by one unit of a company (domestic or international) for goods or
services purchased from another unit of the same firm. As such, a transfer price is needed for every
intrafirm transaction. Where buyer and seller are in different tax jurisdictions (i.e., countries),
governments are concerned with the possibility that transfer prices are raised or lowered from a
“normal” or “appropriate” level in order to avoid taxes.

In most countries, tax authorities have the right to declare a given international transfer price as a tax
avoidance device. Such countries have the right to reset taxable income to a higher level. The motives
for the parent MNE are to minimize taxes, and the difficulty is that the burden of proof is on the
MNE, not the tax collector, to show proof as to why a given transfer price is reasonable.

16. Fund Positioning. What is fund positioning?

Fund positioning is the use of prices or transactions of different kinds to move taxable profits out of
high-tax environments and into low-tax environments. A parent firm wishing to transfer funds out of
a particular country can charge higher prices on goods sold to its subsidiary in that country—to the
degree that government regulations allow. A foreign subsidiary can be financed by the reverse
technique, a lowering of transfer prices. Payment by the subsidiary for imports from its parent or
sister subsidiary transfers funds out of the subsidiary. A higher transfer price permits funds to be
accumulated in the selling country. Multiple sourcing of component parts on a worldwide basis
allows the act of switching between suppliers from within the corporate family to function as a device
to transfer funds.

17. Income Tax Effect. What is the income tax effect, and how may a multinational firm alter transfer
prices as a result of the income tax effect?

A major consideration in setting a transfer price is the income tax effect. Worldwide corporate profits
may be influenced by setting transfer prices to minimize taxable income in a country with a high
income tax rate and to maximize taxable income in a country with a low income tax rate. A parent
wishing to reduce the taxable profits of a subsidiary in a high-tax environment may set transfer prices
at a higher rate to increase the costs of the subsidiary, thereby reducing taxable income.

18. Correct Pricing. What is Section 482 of the U.S. Internal Revenue Code, and what guidelines does it
recommend when setting transfer prices?

Most transfer pricing regulations require the use of a correct or arms-length price on a transaction that
is similar to the price that would be seen in the open market on a similar product or service and
therefore not constructed to pursue some type of fund positioning or other tax reduction or deferral
objective by the company.

19. Cross-Crediting. Define cross-crediting and explain why it may or may not be consistent with a
worldwide tax regime.

Cross-crediting is the ability to cross-credit foreign tax credits with foreign tax deficits in the same
period. If a U.S. multinational remits profits from two different countries, one in a high-tax
environment (relative to the United States) and the other in low-tax environment (relative to the
United States), if the income is from one of the two major “baskets” of foreign source income (active

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or passive), the excess foreign tax credits from one can be cross-credited against the foreign tax
deficits of the other.

20. Check-the-Box. Explain how the check-the-box regulatory change altered the effectiveness of
Subpart F income regulations.

In 1997, the U.S. Treasury attempted to simplify U.S. taxes by introducing what is called check-the-
box subsidiary characterization. The U.S. Treasury changed its required filing practices to allow
multinational firms to categorize subsidiaries for taxation purposes by simply “checking-the-box” on
a single form.

One of the box choices offered, a disregarded entity, allowed the unit to “disappear” for tax purposes
because its results would be consolidated with those of its parent company. These combined units are
termed hybrid entities. In the end, it allowed U.S. multinationals that have tiered ownership of
offshore units to once again begin repositioning profits in low-tax environments and gain essentially
permanent deferral for those earnings. In 2007, the U.S. Treasury codified this process in what is now
referred to as the look-through-rules on this tax treatment of disregarded entities.

21. Measuring Managerial Performance. What role does transfer pricing have within multinational
companies when measuring management performance? How can transfer pricing practices within a
firm conflict with performance measurement?

When a firm is organized with decentralized profit centers, transfer pricing between centers can
disrupt evaluation of managerial performance. Transfer prices that are set high or low for various tax
management purposes also alter the profitability of the unit performance for evaluation of
management. Although not within the control of local unit management, prices are set for the “greater
good” of the entire MNE. In cases such as these, allowances or alternative measures of price or
performance need to be used to adequately evaluate individual unit management performance.

22. Tax Haven Subsidiary. What is a tax haven? Is it the same thing as an international offshore
financial center? What is the purpose of a multinational creating and operating a financial subsidiary
in a tax haven?

A wholly owned subsidiary located in a low-tax environment can act as a tax haven for corporate
funds awaiting reinvestment or repatriation. Tax-haven subsidiaries, categorically referred to as
International Offshore Financial Centers, are partially a result of tax-deferral features on earned
foreign income allowed by some of the parent countries. Tax-haven subsidiaries are typically
established in a country characterized as a low tax on foreign investment or sales income earned by
resident corporations and a low dividend withholding tax on dividends paid to the parent firm.

23. Corporate Inversion. What is a corporate inversion, and why do many U.S. corporations want to
pursue it although it is highly criticized by public and private parties alike?

Corporate inversion is the changing of a company’s country of incorporation. Its purpose is to reduce
its effective global tax liabilities by reincorporating in a lower tax jurisdiction, typically a country
using a territorial tax regime. Although the company’s operations may be completely unchanged and
its corporate headquarters remaining in the original country of incorporation, it would now have a
new corporate home, and its old country of incorporation would now be only one of many other
countries in which the firm operates foreign subsidiaries. A number of U.S. companies have pursued
corporate inversion in recent years in order to lower their effective global tax rates. Politically, in the
United States, it is often seen as unpatriotic and not consistent with being a good corporate citizen.

© 2016 Pearson Education, Inc.
CHAPTER 16
INTERNATIONAL TRADE FINANCE

1. Unaffiliated Buyers. Why might different documentation be used for an export to a nonaffiliated
foreign buyer who is a new customer, as compared with an export to a nonaffiliated foreign buyer to
whom the exporter has been selling for many years?

A new nonaffiliated buyer presents a credit risk for the exporter because the exporter may be unable
to assess the credit worthiness of that importer due to geographic distance, language, culture, or lack
of a record of payments to other suppliers. A letter of credit, accompanied by other documents, allows
the exporter to rely on the credit standing of a bank, which is presumed to be of greater credit
worthiness than just an unknown manufacturing firm.

After successful trade goes on for some time, the importer becomes a known entity, in which case the
exporter will have more faith in the importer’s willingness and ability to pay. Because the letter of
credit and other documents have both a financial cost and a cost for the time and energy involved in
handling the documents, direct billing for exports is easier, faster, and lowers the final end-cost to the
ultimate customer.

2. Affiliated Buyers. For what reason might an exporter use standard international trade documentation
(letter of credit, draft, order bill of lading) on an intrafirm export to its parent or sister subsidiary?

An export to a parent or sister subsidiary has no credit risk because both exporter and importer are
part of the same corporate unit. Nonpayment to an exporter in this situation is just a matter of keeping
the firm’s cash in another corporate account. In fact, very late payment for an export to an affiliated
importer might be desirable because the firm wants to keep cash in one location and not in another.
(This is referred to as “leads and lags.”) Nevertheless, an export to an affiliated buyer might pass
through the standard documentation as a way to obtain financing that is easy to obtain, is possibly
cheaper than alternative sources of short-term financing, or provides some protection against political
or country-based interruption to payment for the transaction.

3. Related Party Trade. What reasons can you give for the observation that intrafirm trade is now
greater than trade between non-affiliated exporters and importers?

The globalization of world business means that multinational firms manufacture as well as sell in
many international markets simultaneously. Firms that move part of their manufacturing operation
abroad to lower costs and thus enable them to compete more effectively in the home and other
markets find themselves specializing in certain products or components in one location and then
exporting those items to sister subsidiaries in other countries. The globalization of enterprise means
that an ever-greater portion of a firms’ products are produced in one country and sold in another.
(This is no different than large domestic U.S. firms manufacturing in one state and selling in another.)

4. Documents. Explain the difference between a letter of credit (L/C) and a draft. How are they linked?

A letter of credit (L/C) is a document issued by a bank promising to pay if certain documents are
delivered to that bank A draft is an order sent to that bank written by a business firm ordering the
bank to make payment. (A personal check is a simple form of a bank draft.) L/Cs and drafts are linked
because the L/C states the conditions under which the bank promises to honor a draft drawn on (e.g.,

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directed to) that bank.

5. Risks. What is the major difference between currency risk and risk of noncompletion? How are these
risks handled in a typical international trade transaction?

Currency risk is the risk that the currency designated for payment of the import changes in value
relative to the other currency. A U.S. firm exporting to France wants dollars, while the French
importer wants to pay euros. If the sale contract specifies payment in dollars, the French importer has
a currency risk—more euros than expected might be needed when payment is due. If the sales
contract specifies payment in euros, the U.S. exporter has a currency risk—fewer dollars than
expected might be received when the euros are exchanged for dollars.

Risk of noncompletion is the risk that one of the parties fails to fulfill its obligations. The importer
may refuse to pay for the goods, or the exporter may fail to ship the goods. Events not under the
control of the parties to the trade, such as major storms, disease epidemics, terrorist acts, or war, may
make completion of the trade impossible. The several documents involved in international trade are
intended to reduce financial loss from noncompletion.

6. Letter of Credit. Identify each party to a letter of credit (L/C) and indicate its responsibility.

A bank issues a letter of credit, promising to pay for an international trade transaction if certain
documents are presented to the bank. The applicant for the letter of credit (usually the importer)
applies to the bank for the letter of credit. The beneficiary of the letter of credit (usually the exporter)
is to receive payment under a set of conditions specified in the letter of credit.

7. Confirmined Letter of Credit. Why would an exporter insist on a confirmed letter of credit?

Most letters of credit are unconfirmed, meaning the exporter relies on the credit quality of the issuing
bank, rather than the importer. However, the exporter may be uncertain of the quality of the issuing
bank, especially if that bank is in a remote country about which the importer knows little. The
confirmation of the letter of credit is by a better-known bank in a major country. For example, a U.S.
exporter with an order from Morocco accompanied by an L/C from a Casablanca bank may not know
if the bank in Casablanca is dependable. The exporter may then ask a Paris bank to guarantee (i.e.,
“confirm”) the L/C of the Casablanca bank. The confirming bank may be acquainted with the
Casablanca bank because it has had long-standing correspondent banking relationships going back to
earlier French control of parts of Morocco, and so be willing—for a fee—to guarantee the L/C of the
Casablanca bank.

8. Documenting an Export of Hard Drives. List the steps involved in the export of computer hard disk
drives from Penang, Malaysia, to San Jose, California, using an unconfirmed letter of credit
authorizing payment on sight.

1. The San Jose importer applies for a letter of credit (L/C) from its California bank.
2. California bank issues an L/C in favor of the San Jose importer and sends the L/C to the
exporter’s Malaysian bank.
3. Malaysian bank advises the Penang exporter of the opening of the L/C.
4. Penang exporter ships the hard drives to the San Jose importer, shipping on an order bill of lading
made deliverable to itself; i.e., deliverable to the exporter itself so that the exporter retains legal
title to the merchandise at this stage of the transaction.

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5. The Penang exporter draws a sight draft against the California bank in accordance with the terms
of the L/C and presents the draft, along with any other required documents, to its own Malaysian
bank.
6. Malaysian bank forwards the draft, accompanied by the order bill of lading and any other
required documents, to the California bank.
7. California bank pays the Malaysian bank for the sight draft, receiving the order bill of lading,
now endorsed by the Malaysian bank. At this point, the California bank has legal title to the
merchandise.
8. Malaysian bank, having received the proceeds from the sale (via the sight draft paid by the
California bank), pays the Penang exporter (less any fees).
9. California bank collects the proceeds of the sale from the San Jose importer and endorses the
order bill of lading over to the importer so the importer, in turn, can collect the merchandise from
the shipper. (The California bank could endorse the order bill of lading over to the San Jose
importer without collecting at that time. In such an instance, the California bank is making an
unsecured loan to the importer, a lending transaction entirely separate from the import/export
transaction.)

9. Documenting an Export of Lumber from Portland to Yokohama. List the steps involved in the
export of lumber from Portland, Oregon, to Yokohama, Japan, using a confirmed letter of credit,
payment to be made in 120 days.

1. Yokohama importer applies for a letter of credit (L/C) from its Japanese bank.
2. Japanese bank issues an L/C in favor of the Yokohama importer and sends the L/C to exporter’s
Oregon bank, asking the Oregon back to confirm (i.e., guarantee) the letter of credit.
3. Oregon bank confirms the L/A and advises Portland exporter of the opening of the L/C.
4. Portland exporter ships the lumber to the Yokohama importer, shipping on an order bill of lading
made deliverable to itself; i.e., deliverable to the exporter itself so that the exporter retains legal
title to the merchandise at this stage of the transaction.
5. The Portland exporter draws a 120-day time draft against the Yokohama bank in accordance with
the terms of the L/C and presents the draft, along with any required documents, to its own Oregon
bank.
6. The Oregon bank endorses (i.e., applies its own guarantee) to the 120-day draft and forwards it,
accompanied by the order bill of lading and any other required documents, to the Japanese bank.
7. The Japanese bank accepts the time draft, which at this point becomes a banker’s acceptance, and
returns the accepted time draft to the exporter. The exporter may (1) hold the acceptance to
maturity or (2) discount it in the acceptance market. At this point, the Japanese bank has legal
title to the lumber.
8. The Japanese bank retains the order bill of lading and other documents for the moment. The
Japanese bank collects the funds from the Yokohama importer, and then gives the order bill of
lading to the importer so the importer may obtain both legal title and physical possession of the
shipment of lumber. Several other possibilities exist, depending on the security arrangements
between the Japanese bank and the Yokohama importer.
9. At maturity (120 days after the Japanese bank accepted the time draft), the holder of the
acceptance presents it to the Japanese bank. The holder might be the exporter or it might be an
investor in banker’s acceptances. If the acceptance is still held by the Portland exporter, that

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exporter presents it to its Oregon bank, which in turn forwards it to the Japanese bank for
collection. When the Oregon bank receives funds, it credits the account of the Portland exporter.

10. Governmentally Supplied Credit. Various governments have established agencies to insure against
nonpayment for exports and/or to provide export credit. This shifts credit risk away from private
banks and to the citizen taxpayers of the country whose government created and backs the agency.
Why would such an arrangement be of benefit to the citizens of that country?

The cost to local taxpayers is a contingent loss, to be covered by the government’s tax revenues in
case the foreign importer fails to pay the exporter. Failure could be deliberate by the importer, but it
could also be imposed because of wars, natural disasters, or other international events. The benefits to
the exporting country are the current jobs created by the manufacturing process and any future jobs
that might follow from recurring exports by the same firm. The government has determined that the
benefits outweigh the possibility of loss.

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CHAPTER 17
FOREIGN DIRECT INVESTMENT AND POLITICAL RISK

1. Evolving into Multinationalism. As a firm evolves from purely domestic into a true multinational
enterprise, it must consider (1) its competitive advantages, (2) its production location, (3) the type of
control it wants to have over any foreign operations, and (4) how much monetary capital to invest
abroad. Explain how each of these considerations is important to the success of foreign operations.

If a firm lacks sufficient competitive advantage to compete effectively in its home market, it is
unlikely to have sufficient advantages of any type to be successful in a foreign market. This is
because the competitive advantages of the home market must be enduring, transferable, and
sufficiently powerful to enable the firm to overcome the assorted difficulties of operating in a foreign
environment. Foreign operations must be located where market imperfections are such that the firm
can take advantage of its competitive advantages to the degree necessary to earn a risk-adjusted rate
of return above the firm’s cost of capital.

The firm must decide upon the degree of control it will need over the foreign operation, recognizing
that greater control usually involves both greater risk and a greater investment. Viewing a spectrum of
degrees of control, licensing, and management contracts provides a low level of control (along with a
low level of financial investment); joint ventures necessitate a somewhat higher level of control; and
greenfield direct investments and/or acquisition of an existing foreign firm require the highest degree
of control (along with a higher level of financial investment).

The spectrum of investment approaches (licensing, management contracts, joint ventures, and direct
investment) require in that order ever-increasing investment of more monetary capital. The firm must
decide if the benefits of greater investment (presumably greater profits, plus possibly acquiring
market share or forestalling competitors from gaining a greater market share) are worth the differing
amounts of monetary capital needed.

2. Market Imperfections. MNEs strive to take advantage of market imperfections in national markets
for products, factors of production, and financial assets. Large international firms are better able to
exploit such imperfections. What are their main competitive advantages?

MNEs strive to take advantage of imperfections in national markets for products, factors of
production, and financial assets. Imperfections in the market for products translate into market
opportunities for MNEs. Large international firms are better able to exploit such competitive factors
as economies of scale, managerial and technological expertise, product differentiation, and financial
strength than are their local competitors. In fact, MNEs thrive best in markets characterized by
international oligopolistic competition, where these factors are particularly critical. In addition, once
MNEs have established a physical presence abroad, they are in a better position compared to purely
domestic firms to identify and implement market opportunities through their own internal information
network.

3. Competitive Advantage. In deciding whether to invest abroad, management must first determine
whether the firm has a sustainable competitive advantage that enables it to compete effectively in the
home market. What are the necessary characteristics of this competitive advantage?

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In deciding whether to invest abroad, management must first determine whether the firm has a
sustainable competitive advantage that enables it to compete effectively in the home market. The
competitive advantage must be firm-specific, transferable, and powerful enough to compensate the
firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and
increased agency costs).

Based on observations of firms that have successfully invested abroad, we can conclude that some of
the competitive advantages enjoyed by MNEs are (1) economies of scale and scope arising from their
large size, (2) managerial and marketing expertise, (3) superior technology owing to their heavy
emphasis on research, (4) financial strength, (5) differentiated products, and sometimes (6)
competitiveness of their home markets.

4. Economies of Scale and Scope. Explain briefly how economies of scale and scope can be developed
in production, marketing, finance, research and development, transportation, and purchasing.

Economies of scale and scope can be developed in production, marketing, finance, research and
development, transportation, and purchasing. In each of these areas, being large has significant
competitive advantages, whether size is due to international or domestic operations. Production
economies can come from the use of large-scale automated plant and equipment or from an ability to
rationalize production through worldwide specialization. For example, some automobile
manufacturers, such as Ford, rationalize manufacturing by producing engines in one country,
transmissions in another, and bodies in another and assembling still elsewhere, with the location often
being dictated by comparative advantage.

Marketing economies occur when firms are large enough to use the most efficient advertising media
to create worldwide brand identification, as well as to establish worldwide distribution, warehousing,
and servicing systems. Financial economies derive from access to the full range of financial
instruments and sources of funds, such as the eurocurrency, euroequity, and eurobond markets. In-
house research and development programs are typically restricted to large firms because of the
minimum-size threshold for establishing a laboratory and scientific staff. Transportation economies
accrue to firms that can ship in carload or shipload lots. Purchasing economies come from quantity
discounts and market power.

5. Competitiveness of the Home Market. A strongly competitive home market can sharpen a firm’s
competitive advantage relative to firms located in less competitive markets. This phenomenon is
known as Porter’s “diamond of national advantage.” Explain what is meant by the “diamond of
national advantage.”

A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms
located in less competitive home markets. This phenomenon is known as the “diamond of national
advantage” (Porter). The diamond has four components. A firm’s success in competing in a particular
industry depends partly on the availability of factors of production (land, labor, capital, and
technology) appropriate for that industry. Countries that are either naturally endowed with the
appropriate factors or able to create them will probably spawn firms that are both competitive at home
and potentially so abroad. For example, a well-educated work force in the home market creates a
competitive advantage for firms in certain high-tech industries.

Firms facing sophisticated and demanding customers in the home market are able to hone their
marketing, production, and quality control skills. Japan is such a market.

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Firms in industries that are surrounded by a critical mass of related industries and suppliers will be
more competitive because of this supporting cast. For example, electronic firms located in centers of
excellence, such as in the San Francisco Bay area, are surrounded by efficient, creative suppliers and
enjoy access to educational institutions at the forefront of knowledge.

A competitive home market forces firms to fine-tune their operational and control strategies for their
specific industry and country environment. Japanese firms learned how to organize to implement their
famous “just-in-time” inventory control system. One key was to use numerous subcontractors and
suppliers that were encouraged to locate near the final assembly plants.

In some cases, home country markets have not been large or competitive, but MNEs located there
have nevertheless developed global niche markets served by foreign subsidiaries. Global competition
in oligopolistic industries substitutes for domestic competition. For example, a number of MNEs
resident in Scandinavia, Switzerland, and the Netherlands fall in this category. Some of these are
Novo Nordisk (Denmark), Norske Hydro (Norway), Nokia (Finland), L.M. Ericsson (Sweden), Astra
(Sweden), ABB (Sweden/Switzerland), Roche Holding (Switzerland), Royal Dutch Shell (the
Netherlands), Unilever (the Netherlands), and Philips (the Netherlands).

6. OLI Paradigm. The OLI Paradigm is an attempt to create an overall framework to explain why
MNEs choose FDI rather than serve foreign markets through alternative modes.

The OLI Paradigm states that a firm must first have some competitive advantage in its home
market—“O” or owner-specific—that can be transferred abroad if the firm is to be successful in
foreign direct investment. Second, the firm must be attracted by specific characteristics of the foreign
market—“L” or location-specific—that will allow it to exploit its competitive advantages in that
market. Third, the firm will maintain its competitive position by attempting to control the entire value
chain in its industry—“I” or internalization. This leads it to foreign direct investment rather than
licensing or outsourcing.

7. Financial Links to OLI. Financial strategies are directly related to the OLI Paradigm.

a. Explain how proactive financial strategies are related to OLI. Proactive financial strategies
can be controlled in advance by the MNE’s financial managers. These include strategies
necessary to gain an advantage from lower global cost and greater availability of capital. Other
proactive financial strategies are negotiating financial subsidies and/or reduced taxation to
increase free cash flows, reducing financial agency costs through FDI, and reducing operating
and transaction exposure through FDI.

b. Explain how reactive financial strategies are related to OLI. Reactive financial strategies
depend on discovering market imperfections. For example, the MNE can exploit misaligned
exchange rates and stock prices. It also needs to react to capital controls that prevent the free
movement of funds and react to opportunities to minimize worldwide taxation.

8. Where to Invest. The decision about where to invest abroad is influenced by behavioral factors.

a. Explain the behavioral approach to FDI. The behavioral approach to analyzing the FDI decision
is typified by the so-called Swedish School of economists. The Swedish School has rather
successfully explained not just the initial decision to invest abroad but also later decisions to
reinvest elsewhere and to change the structure of a firm’s international involvement over time.
Based on the internationalization process of a sample of Swedish MNEs, the economists observed
that these firms tended to invest first in countries that were not too far distant in psychic terms.

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Close psychic distance defined countries with a cultural, legal, and institutional environment
similar to Sweden’s, such as Norway, Denmark, Finland, Germany, and the United Kingdom.
The initial investments were modest in size to minimize the risk of an uncertain foreign
environment. As the Swedish firms learned from their initial investments, they became willing to
take greater risks with respect to both the psychic distance of the countries and the size of the
investments.

b. Explain the international network theory explanation of FDI. As the Swedish MNEs grew and
matured, so did the nature of their international involvement. Today each MNE is perceived as
being a member of an international network, with nodes based in each of the foreign subsidiaries,
as well as the parent firm itself. Centralized (hierarchical) control has given way to decentralized
(heterarchical) control. Foreign subsidiaries compete with each other and with the parent for
expanded resource commitments, thus influencing the strategy and reinvestment decisions. Many
of these MNEs have become political coalitions with competing internal and external networks.
Each subsidiary (and the parent) is embedded in its host country’s network of suppliers and
customers. It is also a member of a worldwide network based on its industry. Finally, it is a
member of an organizational network under the nominal control of the parent firm. Complicating
matters still further is the possibility that the parent itself may have evolved into a transnational
firm, one that is owned by a coalition of investors located in different countries.

9. Exporting versus Producing Abroad. What are the advantages and disadvantages of limiting a
firm’s activities to exporting compared to producing abroad?

There are several advantages to limiting a firm’s activities to exports. Exporting has none of the
unique risks facing FDI, joint ventures, strategic alliances, and licensing. Political risks are minimal.
Agency costs, such as monitoring and evaluating foreign units, are avoided. The amount of front-end
investment is typically lower than in other modes of foreign involvement. Foreign exchange risks
remain, however.

The fact that a significant share of exports (and imports) are executed between MNEs and their
foreign subsidiaries and affiliates further reduces the risk of exports compared to other modes of
involvement.

There are also disadvantages. A firm is not able to internalize and exploit the results of its research
and development as effectively as if it invested directly. The firm also risks losing markets to
imitators and global competitors that might be more cost efficient in production abroad and
distribution. As these firms capture foreign markets, they might become so strong that they can export
back into the domestic exporter’s own market. Remember that defensive FDI is often motivated by
the need to prevent this kind of predatory behavior as well as to preempt foreign markets before
competitors can get started

10. Licensing and Management Contracts Versus Producing Abroad. What are the advantages and
disadvantages of licensing and management contracts compared to producing abroad?

Licensing is a popular method for domestic firms to profit from foreign markets without the need to
commit sizable funds. Because the foreign producer is typically wholly owned locally, political risk is
minimized. In recent years, a number of host countries have demanded that MNEs sell their services
in “unbundled form” rather than only through FDI. Such countries would like their local firms to
purchase managerial expertise and knowledge of product and factor markets through management
contracts, and purchase technology through licensing agreements.

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The main disadvantage of licensing is that license fees are likely to be lower than FDI profits,
although the return on the marginal investment might be higher. Other disadvantages include the
following:
Possible loss of quality control
Establishment of a potential competitor in third-country markets
Possible improvement of the technology by the local licensee, which then enters the original
firm’s home market
Possible loss of opportunity to enter the licensee’s market with FDI later
Risk that technology will be stolen
High agency costs

MNEs have not typically used licensing of independent firms. On the contrary, most licensing
arrangements have been with their own foreign subsidiaries or joint ventures. License fees are a way
to spread the corporate research and development cost among all operating units and a means of
repatriating profits in a form more acceptable to some host countries than dividends.

Management contracts are similar to licensing insofar as they provide for some cash flow from a
foreign source without significant foreign investment or exposure. Management contracts probably
lessen political risk because repatriation of managers is easy. International consulting and engineering
firms traditionally conduct their foreign business on the basis of a management contract.

Whether licensing and management contracts are cost effective compared to FDI depends on the price
host countries will pay for the unbundled services. If the price were high enough, many firms would
prefer to take advantage of market imperfections in an unbundled way, particularly in view of the
lower political, foreign exchange, and business risks. Because we observe MNEs continuing to prefer
FDI, we must assume that the price for selling unbundled services is still too low.

11. Joint Venture versus Wholly Owned Production Subsidiary. What are the advantages and
disadvantages of forming a joint venture to serve a foreign market compared to serving that market
with a wholly owned production subsidiary?

A joint venture is here defined as shared ownership in a foreign business. A foreign business unit that
is partially owned by the parent company is typically termed a foreign affiliate. A foreign business
unit that is 50% or more owned (and therefore controlled) by the parent company is typically
designated a foreign subsidiary. A joint venture would therefore typically fall into the categorization
of being a foreign affiliate but not a foreign subsidiary.

A joint venture between an MNE and a host country partner is a viable strategy if, and only if, the
MNE finds the right local partner. Some of the obvious advantages of having a compatible local
partner are as follows:

a. The local partner understands the customs, mores, and institutions of the local environment. An
MNE might need years to acquire such knowledge on its own with a 100%-owned greenfield
subsidiary.
b. The local partner can provide competent management, not just at the top but also at the middle
levels of management.

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c. If the host country requires that foreign firms share ownership with local firms or investors, 100%
foreign ownership is not a realistic alternative to a joint venture.
d. The local partner’s contacts and reputation enhance access to the host country’s capital markets.
e. The local partner may possess technology that is appropriate for the local environment or perhaps
can be used worldwide.
f. The public image of a firm that is partially locally owned may improve its sales possibilities if the
purpose of the investment is to serve the local market.

Despite this impressive list of advantages, joint ventures are not as common as 100%-owned foreign
subsidiaries because MNEs fear interference by the local partner in certain critical decision areas.
Indeed, what is optimal from the viewpoint of the local venture may be suboptimal for the
multinational operation as a whole. The most important potential conflicts or difficulties are these:

a. Political risk is increased rather than reduced if the wrong partner is chosen. Imagine the standing
of joint ventures undertaken with the family or associates of Suharto in Indonesia or Slobodan
Milosevic in Serbia just before their overthrow. The local partner must be credible and ethical, or
the venture is worse off for being a joint venture.
b. Local and foreign partners may have divergent views about the need for cash dividends or about
the desirability of growth financed from retained earnings versus new financing.
c. Transfer pricing on products or components bought from or sold to related companies creates a
potential for conflict of interest.
d. Control of financing is another problem area. An MNE cannot justify its use of cheap or available
funds raised in one country to finance joint venture operations in another country.
e. Ability of a firm to rationalize production on a worldwide basis can be jeopardized if such
rationalization would act to the disadvantage of local joint venture partners.
f. Financial disclosure of local results might be necessary with locally traded shares, whereas if the
firm is wholly owned from abroad such disclosure is not needed. Disclosure gives nondisclosing
competitors an advantage in setting strategy.

12. Greenfield Investment versus Acquisition. What are the advantages and disadvantages of serving a
foreign market through a greenfield foreign direct investment compared to an acquisition of a local
firm in the target market?

A greenfield investment is defined as establishing a production or service facility starting from the
ground up, i.e., from a green field. Compared to greenfield investment, a cross-border acquisition has
a number of significant advantages. First and foremost, it is quicker. Greenfield investment frequently
requires extended periods of physical construction and organizational development. By acquiring an
existing firm, the MNE can shorten the time required to gain a presence and facilitate competitive
entry into the market. Second, acquisition may be a cost-effective way of gaining competitive
advantages such as technology, brand names valued in the target market, and logistical and
distribution advantages, while simultaneously eliminating a local competitor. Third, international
economic, political, and foreign exchange conditions may result in market imperfections allowing
target firms to be undervalued. Many enterprises throughout Asia have been the target of acquisition
as a result of the Asian economic crisis’ impact on their financial health. Many enterprises were in
dire need of capital injections for competitive survival.

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Cross-border acquisitions are not, however, without their pitfalls. As with all acquisitions—domestic
or international—there are the frequent problems of paying too high a price or suffering a method of
financing that is too costly. Meshing different corporate cultures can be traumatic. Managing the post-
acquisition process is frequently characterized by downsizing to gain economies of scale and scope in
overhead functions. This results in nonproductive impacts on the firm as individuals attempt to save
their own jobs. Internationally, additional difficulties arise from host governments intervening in
pricing, financing, employment guarantees, market segmentation, and general nationalism and
favoritism. In fact, the ability to complete international acquisitions successfully may itself be a test
of the MNE’s competence in the twenty-first century.

13. Cross-Border Strategic Alliance. The term “cross-border strategic alliance” conveys different
meanings to different observers. What are the meanings?

The term strategic alliance conveys different meanings to different observers. In one form of cross-
border strategic alliance, two firms exchange a share of ownership with one another. A strategic
alliance can be a takeover defense if the prime purpose is for a firm to place some of its stock in
stable and friendly hands. If that is all that occurs, it is just another form of portfolio investment.

In a more comprehensive strategic alliance, in addition to exchanging stock, the partners establish a
separate joint venture to develop and manufacture a product or service. Numerous examples of such
strategic alliances can be found in the automotive, electronics, telecommunications, and aircraft
industries. Such alliances are particularly suited to high-tech industries where the cost of research and
development is high and timely introduction of improvements is important.

A third level of cooperation might include joint marketing and servicing agreements in which each
partner represents the other in certain markets. Some observers believe such arrangements begin to
resemble the cartels prevalent in the 1920s and 1930s. Because they reduce competition, cartels have
been banned by international agreements and many national laws.

14. Governance Risk.

a. Define what is meant by the term “governance risk.” Governance risk is the ability to exercise
effective control over an MNE’s operations within a country’s legal and political environment.
For an MNE, however, governance is a subject similar in structure to consolidated profitability—
it must be addressed for the individual business unit and subsidiary, as well as for the MNE as a
whole.

b. What is the most important type of governance risk? The most important type of governance
risk for the MNE on the subsidiary level arises from a goal conflict between bona fide objectives
of host governments and the private firms operating within their spheres of influence.
Governments are normally responsive to a constituency consisting of their citizens. Firms are
responsive to a constituency consisting of their owners and other stakeholders. The valid needs of
these two separate sets of constituents need not be the same, but governments set the rules.
Consequently, governments impose constraints on the activities of private firms as part of their
normal administrative and legislative functioning.

15. Investment Agreement. An investment agreement spells out specific rights and responsibilities of
both the foreign firm and the host government. What are the main financial policies that should be
included in an investment agreement?

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An investment agreement spells out specific rights and responsibilities of both the foreign firm and
the host government. The presence of MNEs is as often sought by development-seeking host
governments as a particular foreign location sought by an MNE. All parties have alternatives and so
bargaining is appropriate.

An investment agreement should spell out policies on financial and managerial issues, including the
following:

The basis on which fund flows, such as dividends, management fees, royalties, patent fees, and
loan repayments, may be remitted
The basis for setting transfer prices
The right to export to third-country markets
Obligations to build, or fund, social and economic overhead projects, such as schools, hospitals,
and retirement systems
Methods of taxation, including the rate, the type of taxation, and means by which the rate base is
determined
Access to host-country capital markets, particularly for long-term borrowing
Permission for 100% foreign ownership versus required local ownership (joint venture)
participation
Price controls, if any, applicable to sales in the host-country markets
Requirements for local sourcing versus import of raw materials and components
Permission to use expatriate managerial and technical personnel, and to bring them and their
personal possessions into the country free of exorbitant charges or import duties
Provision for arbitration of disputes
Provisions for planned divestment, should such be required, indicating how the going concern
will be valued and to whom it will be sold

16. Investment Insurance and Guarantees (OPIC).

a. What is OPIC? The U.S. investment insurance and guarantee program is managed by the
government-owned Overseas Private Investment Corporation (OPIC). OPIC’s stated purpose is to
mobilize and facilitate the participation of U.S. private capital and skills in the economic and
social progress of less developed friendly countries and areas, thereby complementing the
developmental assistance of the United States.

b. What types of political risks can OPIC insure against? OPIC offers insurance coverage for
four separate types of political risk, which have their own specific definitions for insurance
purposes:
Inconvertibility is the risk that the investor will not be able to convert profits, royalties, fees,
or other income, as well as the original capital invested, into dollars.

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Expropriation is the risk that the host government takes a specific step that for one year
prevents the investor or the foreign subsidiary from exercising effective control over use of
the property.
War, revolution, insurrection, and civil strife coverage applies primarily to the damage of
physical property of the insured, although in some cases inability of a foreign subsidiary to
repay a loan because of a war may be covered.
Business income coverage provides compensation for loss of business income resulting from
events of political violence that directly cause damage to the assets of a foreign enterprise.

17. Operating Strategies after the FDI Decision. The following operating strategies, among others, are
expected to reduce damage from political risk. Explain each one and how it reduces damage.

a. Local sourcing. Host governments may require foreign firms to purchase raw material and
components locally as a way to maximize value added benefits and to increase local employment.
From the viewpoint of the foreign firm trying to adapt to host-country goals, local sourcing
reduces political risk, albeit at a trade-off with other factors. Local strikes or other turmoil may
shut down the operation and such issues as quality control, high local prices because of lack of
economies of scale, and unreliable delivery schedules become important. Often the MNE lowers
political risk only by increasing its financial and commercial risk.

b. Facility location. Production facilities may be located so as to minimize risk. The natural
location of different stages of production may be resource-oriented, footloose, or market-oriented.
Oil, for instance, is drilled in and around the Persian Gulf, Russia, Venezuela, and Indonesia. No
choice exists for where this activity takes place. Refining is footloose; a refining facility can be
moved easily to another location or country. Whenever possible, oil companies have built
refineries in politically safe countries, such as Western Europe, or small islands (such as
Singapore or Curaçao), even though costs might be reduced by refining nearer the oil fields. They
have traded reduced political risk and financial exposure for possibly higher transportation and
refining costs.

c. Control of technology. Control of key patents and processes is a viable way to reduce political
risk. If a host country cannot operate a plant because it does not have technicians capable of
running the process, or of keeping up with changed technology, abrogation of an investment
agreement with a foreign firm is unlikely. Control of technology works best when the foreign
firm is steadily improving its technology.

d. Thin equity base. Foreign subsidiaries can be financed with a thin equity base and a large
proportion of local debt. If the debt is borrowed from locally owned banks, host-government
actions that weaken the financial viability of the firm also endanger local creditors.

e. Multiple-source borrowing. If the firm must finance with foreign source debt, it may borrow
from banks in a number of countries rather than just from home country banks. If, for example,
debt is owed to banks in Tokyo, Frankfurt, London, and New York, nationals in a number of
foreign countries have a vested interest in keeping the borrowing subsidiary financially strong. If
the multinational is U.S.-owned, a fallout between the United States and the host government is
less likely to cause the local government to move against the firm if it also owes funds to these
other countries.

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18. Country-Specific Risk. Define the following terms:

a. Transfer risk. Transfer risk is defined as limitations on the MNE’s ability to transfer funds into
and out of a host country without restrictions.

b. Blocked funds. When a government runs short of foreign exchange and cannot obtain additional
funds through borrowing or attracting new foreign investment, it usually limits transfers of
foreign exchange out of the country, a restriction known as blocked funds. In theory this does not
discriminate against foreign-owned firms because it applies to everyone; in practice, foreign firms
have more at stake because of their foreign ownership. Depending on the size of a foreign
exchange shortage, the host government might simply require approval of all transfers of funds
abroad, thus reserving the right to set a priority on the use of scarce foreign exchange in favor of
necessities rather than luxuries. In very severe cases, the government might make its currency
nonconvertible into other currencies, thereby fully blocking transfers of funds abroad. In between
these positions are policies that restrict the size and timing of dividends, debt amortization,
royalties, and service fees.

19. Blocked Funds. Explain the strategies used by an MNE to counter blocked funds.

To transfer funds out of countries having exchange or remittance restrictions, at least six popular
strategies are used by multinational firms:

1. Providing alternative conduits for repatriating funds
2. Transfer pricing goods and services between related units of the MNE
3. Leading and lagging payments
4. Using fronting loans
5. Creating unrelated exports
6. Obtaining special dispensation

20. Cultural and Institutional Risks. Identify and explain the main types of cultural and institutional
risks, except protectionism.

When investing in some of the emerging markets, MNEs that are resident in the most industrialized
countries face serious risks because of cultural and institutional differences. Among many such
differences are the following:
Differences in allowable ownership structures
Differences in human resource norms
Differences in religious heritage
Nepotism and corruption in the host country
Protection of intellectual property rights
Protectionism

21. Strategies to Manage Cultural and Institutional Risks. Explain the strategies that a MNE can use
to manage each of the cultural and institutional risks that you identified in question 9, except
protectionism.

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Lengthy and detailed descriptions are provided in the chapter.

22. Protectionism Defined.

a. Define protectionism and identify the industries that are typically protected. Protectionism is
defined as the attempt by a national government to protect certain of its designated industries
from foreign competition. Industries that are protected are usually related to defense, agriculture,
and “infant” industries.

b. Explain the “infant industry” argument for protectionism. The traditional protectionist
argument is that newly emerging, “infant” industries need protection from foreign competition
until they can get firmly established. The infant industry argument is usually directed at limiting
imports but not necessarily MNEs. In fact, most host countries encourage MNEs to establish
operations in new industries that do not presently exist in the host country. Sometimes the host
country offers foreign MNEs “infant industry” status for a limited number of years. This status
could lead to tax subsidies, construction of infrastructure, employee training, and other aids to
help the MNE get started. Host countries are especially interested in attracting MNEs that
promise to export, either to their own foreign subsidiaries elsewhere or to unrelated parties.

23. Managing Protectionism.

a. What are the traditional methods for countries to implement protectionism? Tariff and
nontariff barriers.

b. What are some typical non-tariff barriers to trade? Non-tariff barriers, which restrict imports
by something other than a financial cost, are often difficult to identify because they are
promulgated as health, safety, or sanitation requirements. A list of the major types of non-tariff
barriers would include those shown in Exhibit 15.6.

c. How can MNEs overcome host country protectionism? MNEs have only a very limited ability
to overcome host country protectionism. However, MNEs do enthusiastically support efforts to
reduce protectionism by joining together in regional markets. The best examples of regional
markets are the European Union (EU), the North American Free Trade Association (NAFTA),
and the Latin American Free Trade Association (MERCOSUR). Among the objectives of
regional markets are elimination of internal trade barriers, such as tariffs and non-tariff barriers,
as well as the free movement of citizens for employment purposes. External trade barriers still
exist.

24. Global-Specific Risks. What are the main types of political risks that are global in origin?

Terrorism and war, anti-globalization efforts, environmental concerns.

25. Managing Global-Specific Risks. What are the main strategies used by MNEs to manage the global-
specific risks you have identified in question 13?

Exhibit 15.6 in the chapter provides a short synthesis of the multitude of strategies applicable to
global-specific risks.

26. U.S. Anti-Bribery Law. The United States has a law prohibiting U.S. firms from bribing foreign
officials and business persons, even in countries where bribery is a normal practice. Some U.S. firms
claim this places the United States at a disadvantage compared to host-country firms and other foreign

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firms that are not hampered by such a law. Discuss the ethics and practicality of the U.S. anti-bribery
law.

MNEs are caught in a dilemma. Should they employ bribery if their local competitors use this
strategy? Alternative strategies are as follows:

Refuse bribery outright, or else demands will quickly multiply.
Retain a local adviser to diffuse demands by local officials, customs agents, and other business
partners.
Do not count on the justice system in many emerging markets because Western-oriented contract
law may not agree with local norms.
Educate both management and local employees about whatever bribery policy the firm intends to
follow.

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Chapter 18
MULTINATIONAL CAPITAL BUDGETING
AND CROSS-BORDER ACQUISITIONS

1. Capital Budgeting Theoretical Framework. Capital budgeting for a foreign project uses the same
theoretical framework as domestic capital budgeting. What are the basic steps in domestic capital
budgeting?

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash
inflows and outflows associated with prospective long-term investment projects. Multinational capital
budgeting techniques are used in traditional FDI analysis, such as the construction of a manufacturing
plant in another country, as well as in the growing field of international mergers and acquisitions.

Capital budgeting for a foreign project uses the same theoretical framework as domestic capital
budgeting—with a few very important differences. The basic steps are as follows:

1. Identify the initial capital invested or put at risk.
2. Estimate cash flows to be derived from the project over time, including an estimate of the
terminal or salvage value of the investment.
3. Identify the appropriate discount rate for determining the present value of the expected cash
flows.
4. Apply traditional capital budgeting decision criteria such as net present value (NPV) and internal
rate of return (IRR) to determine the acceptability of or priority ranking of potential projects

2. Foreign Complexities. Capital budgeting for a foreign project is considerably more complex than the
domestic case. What are the factors that add complexity?

Capital budgeting for a foreign project is considerably more complex than the domestic case. Several
factors contribute to this greater complexity:

Parent cash flows must be distinguished from project cash flows. Each of these two types of
flows contributes to a different view of value.

Parent cash flows often depend on the form of financing. Thus we cannot clearly separate cash
flows from financing decisions, as we can in domestic capital budgeting.

Additional cash flows generated by a new investment in one foreign subsidiary may be in part or
in whole taken away from another subsidiary, with the net result that the project is favorable from
a single subsidiary’s point of view but contributes nothing to worldwide cash flows.

The parent must explicitly recognize remittance of funds because of differing tax systems, legal
and political constraints on the movement of funds, local business norms, and differences in the
way financial markets and institutions function.

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An array of nonfinancial payments can generate cash flows from subsidiaries to the parent,
including payment of license fees and payments for imports from the parent.

Managers must anticipate differing rates of national inflation because of their potential to cause
changes in competitive position, and thus changes in cash flows over time.

Managers must keep the possibility of unanticipated foreign exchange rate changes in mind
because of possible direct effects on the value of local cash flows, as well as indirect effects on
the competitive position of the foreign subsidiary.

Use of segmented national capital markets may create an opportunity for financial gains or may
lead to additional financial costs.

Use of host-government subsidized loans complicates both capital structure and the parent’s
ability to determine an appropriate weighted average cost of capital for discounting purposes.

Managers must evaluate political risk because political events can drastically reduce the value or
availability of expected cash flows.

Terminal value is more difficult to estimate because potential purchasers from the host, parent, or
third countries, or from the private or public sector, may have widely divergent perspectives on
the value to them of acquiring the project.

3. Project versus Parent Valuation. Why should a foreign project be evaluated both from a project and
parent viewpoint?

A strong theoretical argument exists in favor of analyzing any foreign project from the viewpoint of
the parent. Cash flows to the parent are ultimately the basis for dividends to stockholders,
reinvestment elsewhere in the world, repayment of corporate-wide debt, and other purposes that affect
the firm’s many interest groups. However, because most of a project’s cash flows to its parent or to
sister subsidiaries are financial cash flows rather than operating cash flows, the parent viewpoint
usually violates a cardinal concept of capital budgeting, namely, that financial cash flows should not
be mixed with operating cash flows. Often the difference is not important because the two are almost
identical, but in some instances, a sharp divergence in these cash flows will exist.

Evaluation of a project from the local viewpoint serves some useful purposes, but it should be
subordinated to evaluation from the parent’s viewpoint. In evaluating a foreign project’s performance
relative to the potential of a competing project in the same host country, we must pay attention to the
project’s local return. Almost any project should at least be able to earn a cash return equal to the
yield available on host government bonds with a maturity the same as the project’s economic life, if a
free market exists for such bonds. Host government bonds ordinarily reflect the local risk-free rate of
return, including a premium equal to the expected rate of inflation. If a project cannot earn more than
such a bond yield, the parent firm should buy host government bonds rather than invest in a riskier
project.

4. Viewpoint and NPV. Which viewpoint, project or parent, gives results closer to the traditional
meaning of net present value in capital budgeting?

Multinational firms should invest only if they can earn a risk-adjusted return greater than locally
based competitors can earn on the same project. If they are unable to earn superior returns on foreign
projects, their stockholders would be better off buying shares in local firms, where possible, and

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letting those companies carry out the local projects. Apart from these theoretical arguments, surveys
during the past 35 years show that in practice multinational firms continue to evaluate foreign
investments from both the parent and project viewpoint.

5. Viewpoint and Consolidated Earnings. Which viewpoint gives results closer to the effect on
consolidated earnings per share?

The attention paid to project returns in various surveys probably reflects emphasis on maximizing
reported consolidated net earnings per share as a corporate financial goal. As long as foreign earnings
are not blocked, they can be consolidated with the earnings of both the remaining subsidiaries and the
parent. As mentioned previously, U.S. firms must consolidate foreign subsidiaries that are more than
50% owned. If a firm is owned between 20% and 49% by a parent, it is called an affiliate. Affiliates
are consolidated with the parent owner on a pro rata basis. Subsidiaries less than 20% owned are
normally carried as unconsolidated investments. Even in the case of temporarily blocked funds, some
of the most mature MNEs do not necessarily eliminate a project from financial consideration. They
take a very long-run view of world business opportunities.

6. Operating and Financing Cash Flows. Capital projects provide both operating cash flows and
financial cash flows. Why are operating cash flows preferred for domestic capital budgeting but
financial cash flows given major consideration in international projects?

If reinvestment opportunities in the country where funds are blocked are at least equal to the parent
firm’s required rate of return (after adjusting for anticipated exchange rate changes), temporary
blockage of transfer may have little practical effect on the capital budgeting outcome because future
project cash flows will be increased by the returns on forced reinvestment. Because large
multinationals hold a portfolio of domestic and foreign projects, corporate liquidity is not impaired if
a few projects have blocked funds; alternate sources of funds are available to meet all planned uses of
funds. Furthermore, a long-run historical perspective on blocked funds does indeed lend support to
the belief that funds are almost never permanently blocked. However, waiting for the release of such
funds can be frustrating, and sometimes the blocked funds lose value while blocked because of
inflation or unexpected exchange rate deterioration, even though they have been reinvested in the host
country to protect at least part of their value in real terms.

7. Risk-Adjusted Return. Should the anticipated internal rate of return (IRR) for a proposed foreign
project be compared to (a) alternative home country proposals, (b) returns earned by local companies
in the same industry and/or risk class, or (c) both? Justify your answer.

The key to distinction is “risk-adjusted.” Foreign projects will, by most methodologies, be of higher
risk than a domestic or home country project. The anticipated returns should therefore take this into
consideration. At the same time, comparing expected returns with those earned by local companies in
the target markets will not capture the cross-border risks (such as blocked funds) which a foreign
investor may experience. In the end, the answer is (c), both—and more.

8. Blocked Cash Flows. In the evaluation of a potential foreign investment, how should a multinational
firm evaluate cash flows in the host foreign country that are blocked from being repatriated to the
firm’s home country?

The impact of blocked funds on the rate of return from the investor’s perspective would depend on
when the blockage occurs, what reinvestment opportunities exist for the blocked funds in the captive
country, and when the blocked funds would eventually be released to the investor. As with all cash

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flow-based financial analyses, the critical element is when the parent investor will regain the ability to
move the blocked funds freely.

9. Host Country Inflation. How should an MNE factor host country inflation into its evaluation of an
investment proposal?

Inflation is factored into the expected cash flows of the project rate of return. Relative inflation affects
the expected exchange rate due to purchasing power parity.

10. Cost of Equity. A foreign subsidiary does not have an independent cost of capital. However, in order
to estimate the discount rate for a comparable host-country firm, the analyst should try to calculate a
hypothetical cost of capital. How is this done?

As part of this process, the analyst can estimate the subsidiary’s proxy cost of equity by using the
traditional equation: ke = krf +β (km – krf). Define each variable in this equation and explain how the
variable might be different for a proxy host country firm compared to the parent MNE.

The cost of capital and equity of a specific project or subsidiary such as this would be expressed in
local currency terms, while the parent company will ultimately measure the project’s expected returns
and risks based on its own parent currency terms. Therefore, the risk-free rate would be a local
currency government bond. The market return would be the expected return on the market portfolio in
the local market (typically based on recent historical returns). The local project’s beta would be first
based on other like firms in the local market and their historical covariance with the variance of the
market.

11. Viewpoint Cash Flows. What are the differences in the cash flows used in a project point of view
analysis and a parent point of view analysis?

The project viewpoint focuses on the cash flows that are traditionally isolated and analyzed by any
prospective investment—the operational cash flows of the proposed project (initial investment,
operating cash flows, terminal value). The parent viewpoint analysis must, however, focus on those
cash flows that flow between the parent and the project of any kind—including operating cash flows
(operating returns, intra-firm sales and margins, etc.) as well as financing cash flows (dividends as
distributed to the parent from the project).

12. Foreign Exchange Risk and Capital Budgeting. How is foreign exchange risk sensitivity factored
into the capital budgeting analysis of a foreign project?

In the chapter problem, the project team assumed that the Indonesian rupiah would depreciate versus
the U.S. dollar at the purchasing power parity “rate” (approximately 20.767% per year in the baseline
analysis). What if the rate of rupiah depreciation were greater? Although this event would make the
assumed cash flows to Cemex worth less in dollars, operating exposure analysis would be necessary
to determine whether the cheaper rupiah made Semen Indonesia more competitive.

For example, because Semen Indonesia’s exports to Taiwan are denominated in U.S. dollars, a
weakening of the rupiah versus the dollar could result in greater rupiah earnings from those export
sales. This serves to somewhat offset the imported components that Semen Indonesia purchases from
the parent company that are also denominated in U.S. dollars. Semen Indonesia is representative of
firms today which have both cash inflows and outflows denominated in foreign currencies, providing
a partial natural hedge against currency movements.

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What if the rupiah should appreciate against the dollar? The same kind of economic exposure analysis
is needed. In this particular case, we might guess that the effect would be positive on both local sales
in Indonesia and the value in dollars of dividends and license fees paid to Cemex by Semen
Indonesia. Note, however, that an appreciation of the rupiah might lead to more competition within
Indonesia from firms in other countries with now lower cost structures, lessening Semen Indonesia’s
sales.

13. Expropriation Risk. How is expropriation risk factored into the capital budgeting analysis of a
foreign project?

This is typical of the complexity of capturing political risk and its repercussions on financial
performance in a prospective project analysis. Again, if expropriation risk is considered highly
possible, the risk-adjusted return must capture it in some manner.

Many expropriations eventually result in some form of compensation to the former owners. This
compensation can come from a negotiated settlement with the host government or from payment of
political risk insurance by the parent government. Negotiating a settlement takes time, and the
eventual compensation is sometimes paid in installments over a further period. Thus the present value
of the compensation is often much lower than its nominal value. Furthermore, most settlements are
based on book value of the firm at the time of expropriation rather than the firm’s market value.

14. Real Option Analysis. What is real option analysis? How is it a better method of making investment
decisions than traditional capital budgeting analysis?

Real options is a different way of thinking about investment values. At its core, it is a cross between
decision-tree analysis and pure option-based valuation. It is particularly useful when analyzing
investment projects that will follow very different value paths at decision points in time where
management decisions are made regarding project pursuit. This wide range of potential outcomes is at
the heart of real option theory. Real option valuation also allows us to analyze a number of
managerial decisions that in practice characterize many major capital investment projects:

1. The option to defer
2. The option to abandon
3. The option to alter capacity
4. The option to start up or shut down (switching)

Real option analysis treats cash flows in terms of future value in a positive sense, whereas DCF treats
future cash flows negatively (on a discounted basis). Real option analysis is a particularly powerful
device when addressing potential investment projects with extremely long life spans or investments
that do not commence until future dates. Real option analysis acknowledges the way information is
gathered over time to support decision making. Management learns from both active (searching it out)
and passive (observing market conditions) knowledge gathering and then uses this knowledge to
make better decisions.

15. M&A Business Drivers. What are the primary driving forces that motivate cross-border mergers and
acquisitions?

The drivers of M&A activity are both macro in scope—the global competitive environment—and
micro in scope—the variety of industry and firm-level forces and actions driving individual firm

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value. The primary forces of change in the global competitive environment—technological change,
regulatory change, and capital market change—create new business opportunities for MNEs, which
they pursue aggressively.

As opposed to greenfield investment, a cross-border acquisition has a number of significant
advantages. First and foremost, it is quicker. Greenfield investment frequently requires extended
periods of physical construction and organizational development. By acquiring an existing firm, the
MNE shortens the time required to gain a presence and facilitate competitive entry into the market.
Second, acquisition may be a cost-effective way of gaining competitive advantages, such as
technology, brand names valued in the target market, and logistical and distribution advantages, while
simultaneously eliminating a local competitor. Third, specific to cross-border acquisitions,
international economic, political, and foreign exchange conditions may result in market
imperfections, allowing target firms to be undervalued.

16. Three Stages of Cross-Border Acquisitions. What are the three stages of a cross-border acquisition?
What are the core financial elements integral to each stage?

The process of acquiring an enterprise anywhere in the world has three common elements: (1)
identification and valuation of the target, (2) execution of the acquisition offer and purchase—the
tender, and (3) management of the post-acquisition transition.

17. Currency Risks in Cross-Border Acquisitions. What are the currency risks that arise in the process
of making a cross-border acquisition?

The pursuit and execution of a cross-border acquisition poses a number of challenging foreign
currency risks and exposures for an MNE. The nature of the currency exposure related to any specific
cross-border acquisition evolves as the bidding and negotiating process itself evolves across the
bidding, financing, transaction (settlement), and operating stages. The assorted risks, both in the
timing and information related to the various stages of a cross-border acquisition, make the
management of the currency exposures difficult. The uncertainty related to the multitude of stages
declines over time as stages are completed and contracts and agreements reached.

18. Contingent Currency Exposure. What are the largest contingent currency exposures that arise in the
process of pursuing and executing a cross-border acquisition?

The initial bid, if denominated in a foreign currency, creates a contingent foreign currency exposure
for the bidder. This contingent exposure grows in certainty of occurrence over time as negotiations
continue, regulatory requests and approvals are gained, and competitive bidders emerge. Although a
variety of hedging strategies might be employed, the use of a purchased currency call option is the
simplest. The option’s notional principal would be for the estimated purchase price, but the maturity,
for the sake of conservatism, might possibly be significantly longer than probably needed to allow for
extended bidding, regulatory, and negotiation delays.

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Chapter 3

Mini Case

Global Remittances

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Mini-Case: Global Remittances

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Global Remittances
One area within the balance of payments that has received intense interest in the past decade is that of remittances.
The term remittance is a bit tricky. According to the International Monetary Fund (IMF), remittances are international transfers of funds sent by migrant workers from the country where they are working to people, typically family members, in the country from which they originated.
According to the IMF, a migrant is a person who comes to a country and stays, or intends to stay, for a year or more.
As illustrated by Exhibit A, it is estimated that nearly $600 billion was remitted across borders in 2014.
Remittances make up a very small, often negligible cash outflow from sending countries like the United States. They do, however, represent a more significant volume, for example as a percent of GDP, for smaller receiving countries, typically developing countries, sometimes more than 25%. In many cases, this is greater than all development capital and aid flowing to these same countries.
And although the historical record on global remittances is short, as illustrated in Exhibit A, it has shown dramatic growth in the post-2000 period. Its growth has been rapid and dramatic, falling back only temporarily with the global financial crisis of 2008–2009, before returning to its rapid growth path once again from 2010 on.
Remittances largely reflect the income that is earned by migrant or guest workers in one country (source country) and then returned to families or related parties in their home countries (receiving countries). Therefore it is, not surprising that although there are more migrant worker flows between developing countries, the high income developed economies remain the main source of remittances.

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Exhibit A Global Remittance Inflows, 1970–2014 (millions of U.S. dollars)

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Global Remittances
The global economic recession of 2009 resulted in reduced economic activities like construction and manufacturing in the major source countries; as a result, remittance cash flows fell in 2009 but rebounded slightly in 2010.
Most remittances occur as frequent small payments made through wire transfers or a variety of informal channels (some even carried by hand).
The United States Bureau of Economic Analysis (BEA), which is responsible for the compilation and reporting of U.S. balance of payments statistics, classifies migrant remittances as “current transfers” in the current account.
Wider definitions of remittances may also include capital assets that migrants take with them to host countries and similar assets that migrants bring back with them to their home countries.
These values, when compiled, are generally reported under the capital account of the balance of payments.
However, discerning exactly who is a “migrant,” is also an area of some debate. Transfers back to their home country made by individuals who may be working in a foreign country (for example, an expat working for a multinational organization) but who are not considered residents” of that country, may also be considered global remittances under current transfers in the current account.

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Remittances Prices
A number of organizations have devoted significant effort in the past five years to better understanding the costs borne by migrants in transferring funds back to their home countries. The primary concern has been excessive remittance charges—the imposition of what many consider exploitive charges related to the transfer of these frequent small payments.
The G8 countries launched an initiative in 2008 entitled “5 x 5”, to reduce transfer costs from a global average of 10% to 5% in five years (by 2014).
The World Bank supported this initiative by creating Remittance Prices Worldwide (RPW), a global database to monitor remittance price activity across geographic regions.
It was hoped that, through greater transparency and access to transfer cost information, market forces would drive these costs down.
Although the global average cost had fallen to a low of 7.90% in the fall 2014, the program was still clearly far from its goal of 5%.
Funds remitted from the G8 countries themselves fell to 7.49% in 2014, 7.98% for the G20 countries in the same period.
This was particularly relevant given that these are the source countries of a large proportion of all funds remitted.
Little was known of global remittance costs until the World Bank began collecting data in the RPW database. The database collects data on the average cost of transactions conducted along a variety of country corridors globally (country pairs).
Exhibit B provides one sample of what these cost surveys look like. This corridor transaction, the transfer of ZAR 1370 (South African Rand, equivalent to about USD 200 at that time) from South Africa to Malawi was the highest cost corridor in the RPW.

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Exhibit B Remittance Price Comparison for Transfer from South Africa to Malawi

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Remittances Prices
Remittance costs shown in Exhibit B are of two types:
a transaction fee, which in this case ranges between ZAR 43 and 390; and
an exchange rate margin, which is an added cost over and above the organization’s own cost of currency. The resulting total cost per transaction can be seen to rise as high as 30.6% for this specific corridor.
Given that most transfers are by migrant or guest workers back to their home countries and families, and they are members usually of the lowest income groups, these charges—30%—are seen as exploitive.
It should also be noted that these are charges imposed upon the sender, at the origin.
Other fees or charges may occur to the receiver at the point of destination.
It is also obvious from the survey data in Exhibit B that fees and charges may differ dramatically across institutions.
Hence the objective of the program—to provide more information that is publicly available to people remitting funds thereby adding transparency to the process—is clear.
Other results from the RPW cost survey initiative include the following.
China is the most expensive country in the G20 to send money to, while South Africa continues to be the mostly costly G20 country to send money from.
South Asia is the least costly region to send money to, while Sub-Saharan Africa continues to be the most expensive region to send money to globally.
The five highest cost corridors (always available on the RPW Web site) continue to be intra-Africa.
In 2013, India received foreign exchange remittances worth $70 billion from its migratory workforce to retain the top spot in the world amid a broad slowdown caused by regulatory hindrances on both movement of people and capital.

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Exhibit C Remittance Product Use and Cost

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Growing Controversies
With the growth in global remittances has come a growing debate as to what role they do or should play in a country’s balance of payments, and more importantly, economic development.
In some cases, like India, there is growing resistance from the central bank and other banking institutions to allow online payment services like PayPal to process remittances. In other countries, like Honduras, Guatemala, and Mexico, there is growing debate on whether the remittances flow to families, or are actually payments made to a variety of Central American human trafficking smugglers.
In Mexico for example, remittances now make up the second largest source of foreign exchange earnings, second only to oil exports. The Mexican government has increasingly viewed remittances as an integral component of its balance of payments, and in some ways, a “plug” to replace declining export competition and dropping foreign direct investment.
But there is also growing evidence that remittances flow to those who need it most, the lowest income component of the Mexican population, and therefore mitigate poverty and support consumer spending. Former President Vicente Fox was quoted as saying that Mexico’s workers in other countries remitting income home to Mexico are “heroes.”
Mexico’s own statistical agencies also disagree on the size of the funds remittances received, as well as to whom the income is returning (family or non-family interests).

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Global Remittances: Case/Discussion Questions
Where are remittances across borders included within the balance of payments? Are they current or financial account components?
Under what conditions—for example, for which countries currently—are remittances significant contributors to the economy and overall balance of payments?
Why is the cost of remittances the subject of such intense international scrutiny?
What potential do new digital currencies—cryptocurrencies like Bitcoin—have for cross-border remittances?

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