Week 3

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Chapter 5

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Mini Case

The Venezuelan Bolivar Black Market1

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Mini-Case: Venezuelan Bolivar Black Market

It’s not clear whether Mr. Chávez understands what a massive hit Venezuelans take when savings and earnings in dollar terms are cut in half in just three years. Perhaps the political-science student believes that more devalued bolivars makes everyone richer. But one unavoidable conclusion is that he recognized the devaluation as a way to pay for his Bolivarian “missions,” government projects that might restore his popularity long enough to allow him to survive the recall, or survive an audacious decision to squelch it.

— “Money Fun in the Venezuela of Hugo Chávez,” The Wall Street Journal , February 13, 2004, p. A13.

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Venezuelan Bolivar
“Rumor has it that during the year and a half that Venezuelan President Hugo Chávez spent in jail for his role in a 1992 coup attempt against the government, he was a voracious reader. Too bad his prison syllabus seems to have been so skimpy on economics and so heavy on Machiavelli.”
“Money Fun in the Venezuela of Hugo Chávez,”
The Economist, February 13, 2004.

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5-‹#›
The Venezuelan Bolivar Black Market
It’s late afternoon on March 10th, 2004, and Santiago opens the window of his office in Caracas, Venezuela. Immediately he is hit with the sounds rising from the plaza-cars honking, pro-testers banging their pots and pans, street vendors hawking their goods. Since the imposition of a new set of economic policies by President Hugo Chávez in 2002, such sights and sounds had become a fixture of city life in Caracas. Santiago sighed as he yearned for the simplicity of life in the old Caracas.
Santiago’s once-thriving pharmaceutical distribution business had hit hard times.
Since capital controls were implemented in February of 2003, dollars had been hard to come by. He had been forced to pursue various methods-methods that were more expensive and not always legal-to obtain dollars, causing his margins to decrease by 50%. Adding to the strain, the Venezuelan currency, the bolivar (Bs), had been recently devalued (repeatedly).
This had instantly squeezed his margins as his costs had risen directly with the exchange rate. He could not find anyone to sell him dollars. His customers needed supplies and they needed them quickly, but how was he going to come up with the $30,000-the hard currency-to pay for his most recent order?
Political Chaos
Hugo Chávez’s tenure as President of Venezuela had been tumultuous at best since his election in 1998. After repeated recalls, resignations, coups, and re-appointments, the political turmoil had taken its toll on the Venezuelan economy as a whole, and its currency in particular.
The short-lived success of the anti-Chávez coup in 2001, and his nearly immediate return to office, had set the stage for a retrenchment of his isolationist economic and financial policies.

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The Venezuelan Bolivar Black Market
On January 21st, 2003, the bolivar closed at a record low-Bs1853/$. The next day President Hugo Chávez suspended the sale of dollars for two weeks. Nearly instantaneously, an unofficial or black market for the exchange of Venezuelan bolivars for foreign currencies (primarily U.S. dollars) sprouted.
As investors of all kinds sought ways to exit the Venezuelan market, or simply obtain the hard-currency needed to continue to conduct their businesses (as was the case for Santiago), the escalating capital flight caused the black market value of the bolivar to plummet to Bs2500/$ in weeks. As markets collapsed and exchange values fell, the Venezuelan inflation rate soared to more than 30% per annum.
Capital Controls and CADIVI
To combat the downward pressures on the bolivar, the Venezuelan government announced on February 5th, 2003, the passage of the 2003 Exchange Regulations Decree. The Decree took the following actions:
Set the official exchange rate at Bs1596/$ for purchase (bid) and Bs1600/$ for sale (offer);
Established the Comisin de Administracin de Divisas (CADIVI) to control the distribution of foreign exchange; and
Implemented strict price controls to stem inflation triggered by the weaker bolivar and the exchange control-induced contraction of imports.
CADIVI was both the official means and the cheapest means by which Venezuelan citizens could obtain foreign currency. In order to receive an authorization from CADIVI to obtain dollars, an applicant was required to complete a series of forms. The applicant was then required to prove proof of business and asset ownership.

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Exhibit A Official and Gray Market Exchange Rates for the Venezuelan Bolivar

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The Venezuelan Bolivar Black Market
Unofficially, however, there was an additional unstated requirement for permission to obtain foreign currency: authorizations would be reserved for Chávez supporters. In August 2003 an anti-Chávez petition had gained widespread circulation. One million signatures had been collected. Although the government ruled that the petition was invalid, it had used the list of sig-natures to create a database of names and social security numbers that CADIVI utilized to cross-check identities on hard currency requests. President Chávez was quoted as saying “Not one more dollar for the putschits; the bolivars belong to the people.”
Santiago’s Alternatives
Santiago had little luck obtaining dollars via CADIVI to pay for his imports. Because he had signed the petition calling for President Chávez’s removal, he had been listed in the CADIVI database as anti-Chávez, and now could not obtain permission to exchange bolivar for dollars.
The transaction in question was an invoice for $30,000 in pharmaceutical products from his U.S.-based supplier. Santiago intended to resell these products to a large Venezuelan customer who would distribute the products.
This transaction was not the first time that Santiago had been forced to search out alternative sources for meeting his U.S. dollar-obligations. Since the imposition of capital controls, his search for dollars had become a weekly activity for Santiago. In addition to the official process – through CADIVI – he could also obtain dollars through the gray or black markets.

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The Gray Market: CANTV Shares
In May 2003, three months following the implementation of the exchange controls, a window of opportunity had opened up for Venezuelans-an opportunity that allowed investors in the Caracas stock exchange to avoid the tight foreign exchange curbs.
This loophole circumvented the government-imposed restrictions by allowing investors to purchase local shares of the leading telecommunications company CANTV on the Caracas’ bourse, and to then convert those shares into dollar-denominated American Depositary Receipts (ADRs) traded on the NYSE.
The sponsor for CANTV ADRs on the NYSE was the Bank of New York, the leader in ADR sponsorship and management in the U.S. The Bank of New York had suspended trading in CANTV ADRs in February after the passage of the Decree, wishing to determine the legality of trading under the new Venezuelan currency controls.
On May 26th, after concluding that trading was indeed legal under the Decree, trading resumed in CANTV shares. CANTV’s share price and trading volume both soared in the following week.
The share price of CANTV quickly became the primary method of calculating the implicit gray market exchange rate. For example, CANTV shares closed at Bs7945/share on the Caracas bourse on February 6, 2004. That same day, CANTV ADRs closed in New York at $18.84/ADR. Each New York ADR was equal to seven shares of CANTV in Caracas. The implied gray market exchange rate was then calculated as follows:

The official exchange rate on that same day was Bs1598/$. This meant that the gray market rate was quoting the bolivar about 46% weaker against the dollar than what the Venezuelan government officially declared its currency to be worth.

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The Black Market
A third method of obtaining hard currency by Venezuelans was through the rapidly expanding black market. The black market was, as is the case with black markets all over the world, essentially unseen and illegal. It was, however, quite sophisticated, using the services of a stockbroker or banker in Venezuela who simultaneously held U.S. dollar accounts offshore. The choice of a black market broker was a critical one; in the event of a failure to complete the transaction properly there was no legal recourse.
If Santiago wished to purchase dollars on the black market, he would deposit bolivars in his broker’s account in Venezuela. The agreed upon black market exchange rate was determined on the day of the deposit, and usually was within a 20% band of the gray market rate derived from the CANTV share price.
Santiago would then be given access to a dollar-denominated bank account outside of Venezuela in the agreed amount. The transaction took, on average, two business days to settle. The unofficial black market rate was Bs3300/$.
In early 2004 President Chávez had asked Venezuela’s Central Bank to give him “a little billion”-millardito-of its $21 billion in foreign exchange reserves. Chávez argued that the money was actually the people’s, and he wished to invest some of it in the agricultural sector.
The Central Bank refused. Not to be thwarted in its search for funds, the Chávez government announced on February 9, 2004, another devaluation. The bolivar was devalued 17%, falling in official value from Bs1600/$ to Bs1920/$ (see Exhibit A). With all Venezuelan exports of oil being purchased in U.S. dollars, the devaluation of the bolivar meant that the -country’s -proceeds from oil exports grew by the same 17% as the devaluation itself.
The Chávez government argued that the devaluation was necessary because the bolivar was “a variable that cannot be kept frozen, because it prejudices exports and pressures the balance of payments” according to Finance Minister Tobias Nobriega.

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The Black Market
Analysts, however, pointed out that Venezuelan government actually had significant control over its balance of payments: oil was the primary export, the government maintained control over the official access to hard currency necessary for imports, and the Central Bank’s foreign exchange reserves were now over $21 billion.
It’s not clear whether Mr. Chávez understands what a massive hit Venezuelans take when savings and earnings in dollar terms are cut in half in just three years. Perhaps the political-science student believes that more devalued bolivars makes everyone richer. But one unavoidable conclusion is that he recognized the devaluation as a way to pay for his Bolivarian “missions,” government projects that might restore his popularity long enough to allow him to survive the recall, or survive an audacious decision to squelch it.
-“Money Fun in the Venezuela of Hugo Chávez,” Wall Street Journal (eastern edition), February 13, 2004, p. A13.
Time Was Running Out. Santiago received confirmation from CADIVI on the afternoon of March 10th that his latest application for dollars was approved and that he would receive $10,000 at the official exchange rate of Bs1920/$. Santiago attributed his good fortune to the fact that he paid a CADIVI insider an extra 500 bolivars per dollar to expedite his request. Santiago noted with a smile that “the Chávistas need to make money too.”
The noise from the street seemed to be dying with the sun. It was time for Santiago to make some decisions. None of the alternatives were bonita, but if he was to preserve his business, bolivars-at some price-had to be obtained.
Post Script. Although President Chávez died in 2013, and the Venezuelan bolivar has been devalued repeatedly and renamed the bolivar fuerte since the time of this case, it remains a currency that is overvalued by its government and restricted in its exchange, and therefore continues to lead a double life – officially and unofficially.

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Venezuelan Bolivar: Case Questions
Why does a country like Venezuela impose capital controls?
In the case of Venezuela, what is the difference between the gray market and the black market?
Create a financial analysis of Santiago’s choices and use it to make a recommend a solution to his problem.

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5-‹#›
Venezuelan Bolivar: Case Questions
Why does a country like Venezuela impose capital controls?
Capital controls allow a country to preserve a fixed rate of exchange for its currency without risking its holdings of hard currency or foreign currency reserves. The problem, however, is that this control or preservation comes at a substantial cost, as many investors will no longer be willing to invest the same levels of funds in that country, if at all.
Capital controls allow a country, whether Venezuela, Malaysia, or China, to control the level and flow of capital flowing in and out of the country. Because few countries have a problem with too much capital flowing in, but rather with capital out flows – capital flight – capital controls are typically utilized to prohibit massive capital outflows following unfavorable or crises in political or economic events

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Venezuelan Bolivar: Case Questions
In the case of Venezuela, what is the difference between the gray market and the black market?
The black market is the easier to define: the trading of currency through unlicensed or unrecognized organizations or institutions, which by definition in these countries is illegal.
The gray market is the use of a legal process to achieve what is generally considered inconsistent with government desires or policy goals.
Although by definition not illegal, gray market trading is often considered inappropriate and may be politically dangerous by the participants.

Create a financial analysis of Santiago’s choices and use it to make a recommend a solution to his problem.

Venezuelan Bolivar
Item ValueRate (Bs/$) Bolviars
Funds needed $30,000
CADIVI approval $10,000 1,920
500
2,420 24,200,000
Remaining Funds Needed: $20,000
Alternatives:
1. Gray Market $20,000 3,400 68,000,000
2. Black Market $20,000 4,080 81,600,000
(gray + 20%)
3. Vebonos Bonds $20,000 2,973 59,460,000
The solution criteria is to find the “best” effective exchange rate for obtaining the $30,000. The
CADIVI rate, if available for the first $10,000, is the first step. The reamining funds needed,
$20,000, is obtained at the lowest possible cost via the Vebonos Bonds, where the exchange rate of
Bs2973/$ is the cheapest solution.
Solution

Venezuelan Bolivar

Item Value Rate (Bs/$) Bolviars
Funds needed $30,000

CADIVI approval $10,000 1,920
500
2,420 24,200,000

Remaining Funds Needed: $20,000

Alternatives:

1. Gray Market $20,000 3,400 68,000,000

2. Black Market $20,000 4,080 81,600,000
(gray + 20%)

3. Vebonos Bonds $20,000 2,973 59,460,000

The solution criteria is to find the “best” effective exchange rate for obtaining the $30,000. The CADIVI rate, if available for the first $10,000, is the first step. The reamining funds needed, $20,000, is obtained at the lowest possible cost via the Veb

Original

Date US price of VNT Price of TDV.D Implicit rate Official rate
4-Jan-02 15 1700 793 4-Jan-02 Fri 760.35
11-Jan-02 15.25 1625 746 11-Jan-02 Fri 761.66
18-Jan-02 15.68 1700 759 18-Jan-02 Fri 763.1
25-Jan-02 15.82 1720 761 25-Jan-02 Fri 763.49
1-Feb-02 15.9 1750 770 1-Feb-02 Fri 767.34
8-Feb-02 13.99 1675 838 8-Feb-02 Fri 794.33
15-Feb-02 15.92 2050 901 15-Feb-02 Fri 905.63
22-Feb-02 15.3 2350 1075 22-Feb-02 Fri 1070.72
1-Mar-02 15.86 2260 997 1-Mar-02 Fri 1000.75
8-Mar-02 14.2 1900 937 8-Mar-02 Fri 935.46
15-Mar-02 13.69 1800 920 15-Mar-02 Fri 922.51
22-Mar-02 13.49 1700 882 22-Mar-02 Fri 890.79
29-Mar-02 13.8 1705 865 29-Mar-02 920.57
5-Apr-02 13.8 1715.25 870 5-Apr-02 Fri 905.52
12-Apr-02 19.2 2106 768 12-Apr-02 Fri 850.46
19-Apr-02 14 1750 875 19-Apr-02 Fri 841.49
26-Apr-02 14.6 1705 817 26-Apr-02 Fri 840.43
3-May-02 14.55 1700 818 3-May-02 Fri 886.57
10-May-02 14.8 1925 910 10-May-02 Fri 955.58
17-May-02 16.55 2300 973 17-May-02 Fri 1001.56
24-May-02 17.3 2410 975 24-May-02 Fri 1002.48
31-May-02 16.12 2500 1086 31-May-02 Fri 1125.65
7-Jun-02 15.7 2535 1130 7-Jun-02 Fri 1150.38
14-Jun-02 15.45 2585 1171 14-Jun-02 Fri 1192.31
21-Jun-02 13.85 2500 1264 21-Jun-02 Fri 1270.22
28-Jun-02 14.23 2630 1294 28-Jun-02 Fri 1349.96
5-Jul-02 13.44 2400 1250 5-Jul-02 Fri 1285.99
12-Jul-02 13.85 2500 1264 12-Jul-02 Fri 1288.05
19-Jul-02 13.4 2475 1293 19-Jul-02 Fri 1272.54
26-Jul-02 12.2 2210 1268 26-Jul-02 Fri 1319.88
2-Aug-02 12.67 2345 1296 2-Aug-02 Fri 1345.93
9-Aug-02 10.86 2200 1418 9-Aug-02 Fri 1360.12
16-Aug-02 11.48 2200 1341 16-Aug-02 Fri 1367.31
23-Aug-02 11.65 2265 1361 23-Aug-02 Fri 1401.62
30-Aug-02 11 2150 1368 30-Aug-02 Fri 1412.05
6-Sep-02 11.6 2300 1388 6-Sep-02 Fri 1442.25
13-Sep-02 11.37 2375 1462 13-Sep-02 Fri 1464.17
20-Sep-02 10.72 2230 1456 20-Sep-02 Fri 1467.35
27-Sep-02 10.53 2150 1429 27-Sep-02 Fri 1471.74
4-Oct-02 10.41 2250 1513 4-Oct-02 Fri 1488.52
11-Oct-02 11.6 2400 1448 11-Oct-02 Fri 1482.09
18-Oct-02 11.9 2325 1368 18-Oct-02 Fri 1413.76
25-Oct-02 11.95 2350 1377 25-Oct-02 Fri 1433.94
1-Nov-02 12.05 2425 1409 1-Nov-02 Fri 1425.07
8-Nov-02 11.91 2306 1355 8-Nov-02 Fri 1371.08
15-Nov-02 12.05 2300 1336 15-Nov-02 Fri 1351.54
22-Nov-02 12.93 2410 1305 22-Nov-02 Fri 1331.26
29-Nov-02 13.08 2465 1319 29-Nov-02 Fri 1325.49
6-Dec-02 13.55 2465 1273 6-Dec-02 Fri 1316.82
13-Dec-02 14.18 2465 1217 13-Dec-02 Fri 1296.92
20-Dec-02 13.74 2465 1256 20-Dec-02 Fri 1331.39
27-Dec-02 14.15 2465 1219 27-Dec-02 Fri 1385.51
3-Jan-03 12.88 2465 1340 3-Jan-03 Fri 1406.19
10-Jan-03 11.8 2465 1462 10-Jan-03 Fri 1491.82
17-Jan-03 12 2465 1438 17-Jan-03 Fri 1779.14
24-Jan-03 10.9 2465 1583 24-Jan-03 Fri 1921.85
31-Jan-03 10.28 2650 1804 31-Jan-03 Fri 1920.85
7-Feb-03 9.7 2425 1750 7-Feb-03 Fri 1920.59
14-Feb-03 9.45 2290 1696 14-Feb-03 Fri 1598.73
21-Feb-03 10.08 2401 1667 21-Feb-03 Fri 1598.09
28-Feb-03 10.13 2360 1631 28-Feb-03 Fri 1597.31
7-Mar-03 9.84 2300 1636 7-Mar-03 Fri 1597.16
14-Mar-03 9.7 2500 1804 14-Mar-03 Fri 1597.2
21-Mar-03 9.43 2400 1782 21-Mar-03 Fri 1597.75
28-Mar-03 8.96 2329 1820 28-Mar-03 Fri 1597.17
4-Apr-03 9.31 2426 1824 4-Apr-03 Fri 1598.16
11-Apr-03 8.7 2300 1851 11-Apr-03 Fri 1598.68
18-Apr-03 9.61 2280 1661 18-Apr-03 1598.24
25-Apr-03 9.75 2300 1651 25-Apr-03 Fri 1598.68
2-May-03 10.56 2420 1604 2-May-03 Fri 1598.1
9-May-03 10.5 2400 1600 9-May-03 Fri 1597.13
16-May-03 10.45 2630 1762 16-May-03 Fri 1598.48
23-May-03 10.84 3100 2002 23-May-03 Fri 1598.02
30-May-03 12.73 4050 2227 30-May-03 Fri 1597.67
6-Jun-03 12.32 4225 2401 6-Jun-03 Fri 1598.59
13-Jun-03 12.94 4515 2442 13-Jun-03 Fri 1598.2
20-Jun-03 13 4750 2558 20-Jun-03 Fri 1597.18
27-Jun-03 12.75 4715 2589 27-Jun-03 Fri 1598.22
4-Jul-03 12.59 4700 2613 4-Jul-03 Fri 1598.22
11-Jul-03 12.25 4949 2828 11-Jul-03 Fri 1598.26
18-Jul-03 12.04 4815 2799 18-Jul-03 Fri 1598.41
25-Jul-03 12.5 4302 2409 25-Jul-03 Fri 1598.61
1-Aug-03 12.62 4530 2513 1-Aug-03 Fri 1597.71 2363
8-Aug-03 12.71 4500 2478 8-Aug-03 Fri 1598.05
15-Aug-03 12.7 4712.5 2597 15-Aug-03 Fri 1598.15
22-Aug-03 12.85 4700 2560 22-Aug-03 Fri 1598.53
29-Aug-03 13.23 4719 2497 29-Aug-03 Fri 1597.57
5-Sep-03 14.18 5060 2498 5-Sep-03 Fri 1598.02
12-Sep-03 14.11 5000 2481 12-Sep-03 Fri 1597.89 2381
19-Sep-03 14.1 5010 2487 19-Sep-03 Fri 1598.1
26-Sep-03 13.65 4900 2513 26-Sep-03 Fri 1597.41
3-Oct-03 14.1 5030 2497 3-Oct-03 Fri 1597.39
10-Oct-03 14.59 5200 2495 10-Oct-03 Fri 1598.66
17-Oct-03 14.18 5300 2616 17-Oct-03 Fri 1597.57
24-Oct-03 14.5 5360 2588 24-Oct-03 Fri 1597.67
31-Oct-03 14.96 5800 2714 31-Oct-03 Fri 1597.69
7-Nov-03 16.43 6080 2590 7-Nov-03 Fri 1598.67
14-Nov-03 15.87 5630 2483 14-Nov-03 Fri 1597.79
21-Nov-03 15.25 5700 2616 21-Nov-03 Fri 1597.92 2436
28-Nov-03 15.9 5836 2569 28-Nov-03 Fri 1597.66
5-Dec-03 16.62 6405 2698 5-Dec-03 Fri 1598.65
12-Dec-03 15.1 6550 3036 12-Dec-03 Fri 1597.82
19-Dec-03 14.93 6000 2813 19-Dec-03 Fri 1598.69
26-Dec-03 15.08 6300 2924 26-Dec-03 1598.41
2-Jan-04 15.6 6325 2838 2-Jan-04 Fri 1598.52
9-Jan-04 16.97 7005 2890 9-Jan-04 Fri 1598.49 2810
16-Jan-04 17.37 7652 3084 16-Jan-04 Fri 1598.28
23-Jan-04 19.1 8120 2976 23-Jan-04 Fri 1597.93
30-Jan-04 18.28 7906 3027 30-Jan-04 Fri 1598.07
6-Feb-04 18.84 7945 2952 6-Feb-04 Fri 1597.47 3000
13-Feb-04 18.55 8000 3019 13-Feb-04 Fri 1916.92
20-Feb-04 18.5 8400 3178 20-Feb-04 Fri 1917.26 3100
27-Feb-04 18.53 8600 3249 27-Feb-04 Fri 1917.17 3300
5-Mar-04 19 9300 3426 5-Mar-04 Fri 1916.57 3226
12-Mar-04 18.2 8851 3404 12-Mar-04 Fri 1918.94 3500
19-Mar-04 18.47 8650 3278 19-Mar-04 Fri 1917.86

Original

2362.6782884311 760.35 793.3333333333
37841 761.66 745.9016393443
37848 763.1 758.9285714286
37855 763.49 761.0619469027
37862 767.34 770.4402515723
37869 794.33 838.0986418871
2380.5102763997 905.63 901.3819095477
37883 1070.72 1075.1633986928
37890 1000.75 997.4779319042
37897 935.46 936.6197183099
37904 922.51 920.3798392988
37911 890.79 882.1349147517
37918 920.57 864.8550724638
37925 905.52 870.0543478261
37932 850.46 767.8125
37939 841.49 875
2436.3934426229 840.43 817.4657534247
37953 886.57 817.8694158076
37960 955.58 910.472972973
37967 1001.56 972.8096676737
37974 1002.48 975.1445086705
37981 1125.65 1085.6079404466
37988 1150.38 1130.2547770701
2809.510901591 1192.31 1171.1974110032
38002 1270.22 1263.5379061372
38009 1349.96 1293.7456078707
38016 1285.99 1250
38023 1288.05 1263.5379061372
38030 1272.54 1292.9104477612
38037 1319.88 1268.0327868853
38044 1345.93 1295.5801104972
3226.3157894737 1360.12 1418.0478821363
1367.31 1341.4634146342
1401.62 1360.9442060086
1412.05 1368.1818181818
1442.25 1387.9310344828
1464.17 1462.18117854
1467.35 1456.1567164179
1471.74 1429.2497625831
1488.52 1512.9682997118
1482.09 1448.275862069
1413.76 1367.6470588235
1433.94 1376.5690376569
1425.07 1408.7136929461
1371.08 1355.3316540722
1351.54 1336.0995850622
1331.26 1304.7177107502
1325.49 1319.1896024465
1316.82 1273.4317343173
1296.92 1216.8547249647
1331.39 1255.8224163028
1385.51 1219.4346289753
1406.19 1339.6739130435
1491.82 1462.2881355932
1779.14 1437.9166666667
1921.85 1583.0275229358
1920.85 1804.4747081712
1920.59 1750
1598.73 1696.2962962963
1598.09 1667.3611111111
1597.31 1630.7996051333
1597.16 1636.1788617886
1597.2 1804.1237113402
1597.75 1781.5482502651
1597.17 1819.53125
1598.16 1824.0601503759
1598.68 1850.5747126437
1598.24 1660.7700312175
1598.68 1651.282051282
1598.1 1604.1666666667
1597.13 1600
1598.48 1761.7224880383
1598.02 2001.8450184502
1597.67 2227.0227808327
1598.59 2400.5681818182
1598.2 2442.4265842349
1597.18 2557.6923076923
1598.22 2588.6274509804
1598.22 2613.1850675139
1598.26 2828
1598.41 2799.4186046512
1598.61 2409.12
1597.71 2512.6782884311
1598.05 2478.3634933123
1598.15 2597.4409448819
1598.53 2560.3112840467
1597.57 2496.8253968254
1598.02 2497.8843441467
1597.89 2480.5102763997
1598.1 2487.2340425532
1597.41 2512.8205128205
1597.39 2497.1631205674
1598.66 2494.8594928033
1597.57 2616.3610719323
1597.67 2587.5862068965
1597.69 2713.9037433155
1598.67 2590.3834449178
1597.79 2483.3018273472
1597.92 2616.3934426229
1597.66 2569.3081761006
1598.65 2697.6534296029
1597.82 3036.4238410596
1598.69 2813.1279303416
1598.41 2924.4031830239
1598.52 2838.141025641
1598.49 2889.510901591
1598.28 3083.7075417386
1597.93 2975.9162303665
1598.07 3027.4617067834
1597.47 2951.9639065817
1916.92 3018.8679245283
1917.26 3178.3783783784
1917.17 3248.7857528332
1916.57 3426.3157894737
1918.94 3404.2307692308
1917.86 3278.2891174878

Bond issue annoucement day
Official rate
Implicit rate
Official and “Implied” Foreign Exchange Rate

Official

Date Official rate
4-Jan-02 760.35
11-Jan-02 761.66
18-Jan-02 763.1
25-Jan-02 763.49
1-Feb-02 767.34
8-Feb-02 794.33
15-Feb-02 905.63
22-Feb-02 1070.72
1-Mar-02 1000.75
8-Mar-02 935.46
15-Mar-02 922.51
22-Mar-02 890.79
29-Mar-02 920.57
5-Apr-02 905.52
12-Apr-02 850.46
19-Apr-02 841.49
26-Apr-02 840.43
3-May-02 886.57
10-May-02 955.58
17-May-02 1001.56
24-May-02 1002.48
31-May-02 1125.65
7-Jun-02 1150.38
14-Jun-02 1192.31
21-Jun-02 1270.22
28-Jun-02 1349.96
5-Jul-02 1285.99
12-Jul-02 1288.05
19-Jul-02 1272.54
26-Jul-02 1319.88
2-Aug-02 1345.93
9-Aug-02 1360.12
16-Aug-02 1367.31
23-Aug-02 1401.62
30-Aug-02 1412.05
6-Sep-02 1442.25
13-Sep-02 1464.17
20-Sep-02 1467.35
27-Sep-02 1471.74
4-Oct-02 1488.52
11-Oct-02 1482.09
18-Oct-02 1413.76
25-Oct-02 1433.94
1-Nov-02 1425.07
8-Nov-02 1371.08
15-Nov-02 1351.54
22-Nov-02 1331.26
29-Nov-02 1325.49
6-Dec-02 1316.82
13-Dec-02 1296.92
20-Dec-02 1331.39
27-Dec-02 1385.51
3-Jan-03 1406.19
10-Jan-03 1491.82
17-Jan-03 1779.14
24-Jan-03 1921.85
31-Jan-03 1920.85
7-Feb-03 1920.59
14-Feb-03 1598.73
21-Feb-03 1598.09
28-Feb-03 1597.31
7-Mar-03 1597.16
14-Mar-03 1597.2
21-Mar-03 1597.75
28-Mar-03 1597.17
4-Apr-03 1598.16
11-Apr-03 1598.68
18-Apr-03 1598.24
25-Apr-03 1598.68
2-May-03 1598.1
9-May-03 1597.13
16-May-03 1598.48
23-May-03 1598.02
30-May-03 1597.67
6-Jun-03 1598.59
13-Jun-03 1598.2
20-Jun-03 1597.18
27-Jun-03 1598.22
4-Jul-03 1598.22
11-Jul-03 1598.26
18-Jul-03 1598.41
25-Jul-03 1598.61
1-Aug-03 1597.71
8-Aug-03 1598.05
15-Aug-03 1598.15
22-Aug-03 1598.53
29-Aug-03 1597.57
5-Sep-03 1598.02
12-Sep-03 1597.89
19-Sep-03 1598.1
26-Sep-03 1597.41
3-Oct-03 1597.39
10-Oct-03 1598.66
17-Oct-03 1597.57
24-Oct-03 1597.67
31-Oct-03 1597.69
7-Nov-03 1598.67
14-Nov-03 1597.79
21-Nov-03 1597.92
28-Nov-03 1597.66
5-Dec-03 1598.65
12-Dec-03 1597.82
19-Dec-03 1598.69
26-Dec-03 1598.41
2-Jan-04 1598.52
9-Jan-04 1598.49
16-Jan-04 1598.28
23-Jan-04 1597.93
30-Jan-04 1598.07
6-Feb-04 1597.47
13-Feb-04 1916.92
20-Feb-04 1917.26
27-Feb-04 1917.17
5-Mar-04 1916.57
12-Mar-04 1918.94
19-Mar-04 1917.86

Official

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Graph1

Bolivar peaks
at Bs1853/US$;
temporary capital
controls implemented
On February 5, 2003, the CADIVI is established
to control currency distribution; the bolivar is
officially reset to Bs1596-1600/US$ (bid-offer)
Bolivar is once again officially
devalued, from Bs1598/US$
to Bs1917/US$

Reserves

Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Jan-04 Feb-04 Mar-04
17.90 16.00 14.80 14.00 13.75 13.90 12.80 12.30 12.60 12.80 12.50 11.00 11.79 10.54 9.77 9.46 9.96 9.89 10.62 11.50 11.24 11.65 12.34 12.38 11.37 11.24 11.81 13.50 14.32 14.88 17.29 17.29 17.29 18.79 20.01 19.80 20.63 21.59 21.91 22.61

Date Foreign Reserves
Jan-01 17.90
Feb-01 16.00
Mar-01 14.80
Apr-01 14.00
May-01 13.75
Jun-01 13.90
Jul-01 12.80
Aug-01 12.30
Sep-01 12.60
Oct-01 12.80
Nov-01 12.50
Dec-01 11.00
Jan-02 11.79
Feb-02 10.54
Mar-02 9.77
Apr-02 9.46
May-02 9.96
Jun-02 9.89
Jul-02 10.62
Aug-02 11.50
Sep-02 11.24
Oct-02 11.65
Nov-02 12.34
Dec-02 12.38
Jan-03 11.37
Feb-03 11.24
Mar-03 11.81
Apr-03 13.50
May-03 14.32
Jun-03 14.88
Jul-03 17.29
Aug-03 17.29
Sep-03 17.29
Oct-03 18.79
Nov-03 20.01
Dec-03 19.80
Jan-04 20.63
Jan-04 21.59
Feb-04 21.91
Mar-04 22.61

Yields

1/8/99 1/15/99 1/22/99 1/29/99 2/5/99 2/12/99 2/19/99 2/26/99 3/5/99 3/12/99 3/19/99 3/26/99 4/1/99 4/9/99 4/16/99 4/23/99 4/30/99 5/7/99 5/14/99 5/21/99 5/28/99 6/4/99 6/11/99 6/18/99 6/25/99 7/2/99 7/9/99 7/16/99 7/23/99 7/30/99 8/6/99 8/13/99 8/20/99 8/27/99 9/3/99 9/10/99 9/17/99 9/24/99 10/1/99 10/8/99 10/15/99 10/22/99 10/29/99 11/5/99 11/12/99 11/19/99 11/26/99 12/3/99 12/10/99 12/17/99 12/23/99 12/31/99 1/7/00 1/14/00 1/21/00 1/28/00 2/4/00 2/11/00 2/18/00 2/25/00 3/3/00 3/10/00 3/17/00 3/24/00 3/31/00 4/7/00 4/14/00 4/20/00 4/28/00 5/5/00 5/12/00 5/19/00 5/26/00 6/2/00 6/9/00 6/16/00 6/23/00 6/30/00 7/7/00 7/14/00 7/21/00 7/28/00 8/4/00 8/11/00 8/18/00 8/25/00 9/1/00 9/8/00 9/15/00 9/22/00 9/29/00 10/6/00 10/13/00 10/20/00 10/27/00 11/3/00 11/10/00 11/17/00 11/24/00 12/1/00 12/8/00 12/15/00 12/22/00 12/29/00 1/5/01 1/12/01 1/19/01 1/26/01 2/2/01 2/9/01 2/16/01 2/23/01 3/2/01 3/9/01 3/16/01 3/23/01 3/30/01 4/6/01 4/12/01 4/20/01 4/27/01 5/4/01 5/11/01 5/18/01 5/25/01 6/1/01 6/8/01 6/15/01 6/22/01 6/29/01 7/6/01 7/13/01 7/20/01 7/27/01 8/3/01 8/10/01 8/17/01 8/24/01 8/31/01 9/7/01 9/14/01 9/21/01 9/28/01 10/5/01 10/12/01 10/19/01 10/26/01 11/2/01 11/9/01 11/16/01 11/23/01 11/30/01 12/7/01 12/14/01 12/21/01 12/28/01
15.1770 16.6420 16.9400 16.3580 16.7930 16.2910 16.3630 16.4010 17.1050 15.9560 16.2270 16.2960 15.0660 15.4960 13.8610 13.3110 12.8540 12.7490 13.1710 14.4320 14.4880 14.1090 14.7710 13.6310 14.7150 14.2710 14.2180 14.6040 14.9740 14.8340 15.4390 14.9540 15.1950 15.0040 15.1990 14.5030 14.5020 14.1750 14.3350 14.3890 14.6110 14.1730 13.8610 13.8100 13.5810 13.7590 13.7700 14.3890 14.3670 14.3240 14.3900 14.0960 14.2830 14.2840 14.0720 14.5830 14.3300 14.2880 14.0980 13.9750 13.8220 13.6740 13.8230 14.0490 14.1860 14.2920 14.5670 14.5780 14.5890 15.8410 15.9070 15.6450 15.4860 14.3460 14.1850 14.1860 14.4020 14.2940 14.0820 13.9790 13.8770 14.0850 13.7480 13.6300 13.8820 13.8320 13.6830 13.4400 13.7850 13.9880 13.8550 13.7830 14.1440 14.5230 14.5230 14.2820 14.3580 14.1970 14.0910 14.1970 14.4690 14.7500 14.5250 14.6380 14.0940 14.0750 13.8690 13.7390 13.5420 13.3890 13.4190 13.6340 13.4030 13.2720 13.5690 13.8980 13.6470 13.4990 13.4220 13.6750 13.4890 13.3930 13.4700 13.3550 13.4220 13.5780 13.3000 13.3090 13.4050 13.5600 13.6690 14.1620 13.6910 13.8020 13.7530 13.6050 13.8060 13.8070 13.6290 13.7500 13.9640 13.8610 14.0670 14.2680 14.3860 14.1390 14.1710 14.3320 14.2240 14.6070 14.3540 14.3320 14.2790 14.4640 15.0370 14.8960
5.5260 5.3760 5.3210 5.3030 5.5580 5.6780 5.6420 5.7780 5.8550 5.7670 5.7670 5.8360 5.9150 5.6920 5.7870 5.8180 5.8950 6.0400 6.1010 5.9940 6.0500 6.1650 6.3660 6.2100 6.3880 6.1970 6.2050 6.0770 6.2170 6.2960 6.3700 6.3760 6.2850 6.2640 6.3280 6.3490 6.3610 6.2460 6.4570 6.4850 6.5430 6.6330 6.3950 6.2970 6.2660 6.3810 6.4550 6.4750 6.3700 6.6130 6.6960 6.6920 6.7010 6.8100 6.8230 6.5420 6.4000 6.4960 6.3460 6.3550 6.3010 6.3780 6.1950 6.2060 6.0600 5.9240 6.0460 6.0770 6.2060 6.4680 6.4840 6.4970 6.3300 6.2050 6.1470 6.1220 6.2850 6.1550 6.1310 6.1340 6.0320 6.0190 5.9380 5.9410 5.9030 5.8830 5.8670 5.9080 6.0890 6.0960 6.0580 6.0320 5.9920 5.9060 5.9180 6.0350 6.0230 5.9190 5.8240 5.7800 5.6750 5.5590 5.5140 5.5830 5.5200 5.7400 5.6590 5.7430 5.6010 5.5690 5.6690 5.6780 5.5610 5.5080 5.4360 5.4660 5.6300 5.6030 5.7760 5.9230 5.9340 5.7730 6.0260 5.9140 6.0190 5.8730 5.8920 5.8300 5.7150 5.8990 5.8980 5.7850 5.6860 5.6740 5.7010 5.6310 5.5400 5.5560 5.4750 5.4860 5.4480 5.6660 5.4960 5.4040 5.5180 5.4470 5.3460 5.1630 5.0740 5.5220 5.6300 5.5560 5.9000 5.8840 5.7650 5.8310

1/5/01 1/12/01 1/19/01 1/26/01 2/2/01 2/9/01 2/16/01 2/23/01 3/2/01 3/9/01 3/16/01 3/23/01 3/30/01 4/6/01 4/12/01 4/20/01 4/27/01 5/4/01 5/11/01 5/18/01 5/25/01 6/1/01 6/8/01 6/15/01 6/22/01 6/29/01 7/6/01 7/13/01 7/20/01 7/27/01 8/3/01 8/10/01 8/17/01 8/24/01 8/31/01 9/7/01 9/14/01 9/21/01 9/28/01 10/5/01 10/12/01 10/19/01 10/26/01 11/2/01 11/9/01 11/16/01 11/23/01 11/30/01 12/7/01 12/14/01 12/21/01 12/28/01 1/4/02 1/11/02 1/18/02 1/25/02 2/1/02 2/8/02 2/15/02 2/22/02 3/1/02 3/8/02 3/15/02 3/22/02 3/28/02 4/5/02 4/12/02 4/19/02 4/26/02 5/3/02 5/10/02 5/17/02 5/24/02 5/31/02 6/7/02 6/14/02 6/21/02 6/28/02 7/5/02 7/12/02 7/19/02 7/26/02 8/2/02 8/9/02 8/16/02 8/23/02 8/30/02 9/6/02 9/13/02 9/20/02 9/27/02 10/4/02 10/11/02 10/18/02 10/25/02 11/1/02 11/8/02 11/15/02 11/22/02 11/29/02 12/6/02 12/13/02 12/20/02 12/27/02 1/3/03 1/10/03 1/17/03 1/24/03 1/31/03 2/7/03 2/14/03 2/21/03 2/28/03 3/7/03 3/14/03 3/21/03 3/28/03 4/4/03 4/11/03 4/17/03 4/25/03 5/2/03 5/9/03 5/16/03 5/23/03 5/30/03 6/6/03 6/13/03 6/20/03 6/27/03 7/3/03 7/11/03 7/18/03 7/25/03 8/1/03 8/8/03 8/15/03 8/22/03 8/29/03 9/5/03 9/12/03 9/19/03 9/26/03 10/3/03 10/10/03 10/17/03 10/24/03 10/31/03 11/7/03 11/14/03 11/21/03 11/28/03 12/5/03 12/12/03 12/19/03 12/26/03 1/2/04 1/9/04 1/16/04 1/23/04 1/30/04 2/6/04 2/13/04 2/20/04 2/27/04 3/5/04 3/12/04 3/19/04 3/26/04 4/2/04 4/8/04 4/16/04 4/23/04
14.0940 14.0750 13.8690 13.7390 13.5420 13.3890 13.4190 13.6340 13.4030 13.2720 13.5690 13.8980 13.6470 13.4990 13.4220 13.6750 13.4890 13.3930 13.4700 13.3550 13.4220 13.5780 13.3000 13.3090 13.4050 13.5600 13.6690 14.1620 13.6910 13.8020 13.7530 13.6050 13.8060 13.8070 13.6290 13.7500 13.9640 13.8610 14.0670 14.2680 14.3860 14.1390 14.1710 14.3320 14.2240 14.6070 14.3540 14.3320 14.2790 14.4640 15.0370 14.8960 14.5550 14.8400 14.9230 15.1980 15.5580 15.8960 14.6190 14.4210 14.0490 13.8760 13.5760 13.8040 13.6940 13.8750 12.2390 13.4300 13.4680 13.2680 13.3340 13.2410 13.3920 13.6940 14.0820 14.0310 15.0890 14.5480 15.0910 14.9150 14.9390 15.0350 14.6890 14.3580 14.1450 13.8370 13.6380 13.5420 13.6900 13.9940 14.0870 13.9620 13.6390 13.7580 13.5310 13.5800 13.6150 13.5420 13.1810 13.1860 13.0710 13.5430 13.8170 13.9190 14.6450 15.1690 15.4150 15.4540 14.8550 14.9960 15.4710 15.2640 15.3520 15.1840 14.7270 15.0050 15.5530 15.1230 15.0510 14.2200 14.6690 14.4360 14.0830 13.7550 13.3850 13.1780 12.6430 12.2660 12.5580 12.8630 12.6630 12.6460 12.3930 12.4190 12.7360 12.8430 12.6950 12.3320 12.3670 12.3180 12.2940 12.1080 12.0840 12.1480 11.7940 11.8330 11.8020 11.6130 11.5170 11.3650 11.3360 11.2940 10.6100 10.4510 10.2350 10.2660 10.2350 9.8970 10.3590 10.3290 10.5300 10.3920 10.5190 10.9800 11.2030 10.9690 10.6890 10.4770 10.4580 10.7150 10.5210 10.9140 11.0510
5.5200 5.7400 5.6590 5.7430 5.6010 5.5690 5.6690 5.6780 5.5610 5.5080 5.4360 5.4660 5.6300 5.6030 5.7760 5.9230 5.9340 5.7730 6.0260 5.9140 6.0190 5.8730 5.8920 5.8300 5.7150 5.8990 5.8980 5.7850 5.6860 5.6740 5.7010 5.6310 5.5400 5.5560 5.4750 5.4860 5.4480 5.6660 5.4960 5.4040 5.5180 5.4470 5.3460 5.1630 5.0740 5.5220 5.6300 5.5560 5.9000 5.8840 5.7650 5.8310 5.8600 5.6110 5.6060 5.7330 5.6440 5.6230 5.6030 5.5770 5.7100 5.9520 5.9910 6.0340 6.0370 5.8540 5.8370 5.8720 5.7550 5.7240 5.7820 5.9310 5.8410 5.7890 5.8240 5.5900 5.5790 5.6900 5.7030 5.5140 5.5310 5.4870 5.3600 5.2950 5.2770 5.2020 5.1290 5.0650 4.9420 4.8970 4.8580 4.8860 4.9830 5.2610 5.2500 5.1670 4.9530 5.0940 5.1860 5.2330 5.1540 5.1110 5.0620 4.9390 5.1240 5.2250 5.0860 4.9950 5.0070 4.9520 5.0290 4.9800 4.7920 4.7680 4.8250 5.1630 5.0280 5.0690 5.0580 4.9990 4.9290 4.9290 4.7580 4.5110 4.3390 4.4450 4.4630 4.2280 4.5170 4.6630 4.7330 4.7350 4.9890 5.1910 5.4490 5.3470 5.5330 5.3920 5.3560 5.3390 5.2740 5.1700 5.0450 5.2090 5.2720 5.3650 5.2030 5.2470 5.3680 5.1610 5.1060 5.2440 5.1440 5.1850 5.0570 5.0640 5.2840 5.0490 4.9630 5.0230 5.0530 5.0090 4.9900 5.0220 4.9160 4.7900 4.7450 4.7590 4.8230 5.0560 5.1230 5.2710 5.3350

Date Vz Debt Yield US Treasury
9/19/97 9.7030 6.3730
9/26/97 9.7240 6.3650
10/3/97 9.5340 6.3090
10/10/97 9.7510 6.4350
10/17/97 9.7780 6.4400
10/24/97 10.1240 6.2900
10/31/97 11.3160 6.1450
11/7/97 11.2330 6.1890
11/14/97 11.3370 6.1330
11/21/97 10.5780 6.0830
11/28/97 10.5780 6.0830
12/5/97 10.1860 6.1210
12/12/97 10.9300 5.9900
12/19/97 11.0030 5.9600
12/26/97 10.6540 5.9540
1/2/98 10.3700 5.8990
1/9/98 10.8660 5.7560
1/16/98 10.9840 5.8470
1/23/98 11.1670 6.0190
1/30/98 10.6000 5.8460
2/6/98 10.3790 5.9550
2/13/98 10.4890 5.8860
2/20/98 10.5510 5.8990
2/27/98 10.5000 5.9460
3/6/98 10.4300 6.0470
3/13/98 10.3160 5.9090
3/20/98 10.2210 5.9070
3/27/98 10.1390 5.9810
4/3/98 10.4900 5.8080
4/9/98 10.3250 5.9060
4/17/98 10.5080 5.9040
4/24/98 10.5510 5.9780
5/1/98 10.4340 5.9760
5/8/98 10.7270 6.0120
5/15/98 10.7390 6.0150
5/22/98 10.9010 5.9540
5/29/98 11.1010 5.8570
6/5/98 10.9140 5.8400
6/12/98 11.3710 5.7070
6/19/98 11.4850 5.7400
6/26/98 12.0100 5.6930
7/2/98 12.2890 5.6590
7/10/98 13.0190 5.6780
7/17/98 12.3560 5.7980
7/24/98 13.0930 5.7280
7/31/98 14.0000 5.7640
8/7/98 15.8040 5.6660
8/14/98 15.8060 5.6340
8/21/98 20.8590 5.5730
8/28/98 23.0330 5.4780
9/4/98 23.7700 5.4040
9/11/98 23.3280 5.3560
9/18/98 21.0980 5.3100
9/25/98 17.2480 5.2980
10/2/98 16.0090 5.0360
10/9/98 14.5900 5.4090
10/16/98 14.5900 5.2340
10/23/98 15.6110 5.3920
10/30/98 15.6760 5.3330
11/6/98 14.8170 5.5790
11/13/98 16.1760 5.4300
11/20/98 15.6750 5.4120
11/27/98 16.4210 5.3810
12/4/98 16.7840 5.2980
12/11/98 16.7850 5.2880
12/18/98 16.0750 5.2730
12/24/98 16.0080 5.4940
12/31/98 15.2980 5.3510
1/8/99 15.1770 5.5260
1/15/99 16.6420 5.3760
1/22/99 16.9400 5.3210
1/29/99 16.3580 5.3030
2/5/99 16.7930 5.5580
2/12/99 16.2910 5.6780
2/19/99 16.3630 5.6420
2/26/99 16.4010 5.7780
3/5/99 17.1050 5.8550
3/12/99 15.9560 5.7670
3/19/99 16.2270 5.7670
3/26/99 16.2960 5.8360
4/1/99 15.0660 5.9150
4/9/99 15.4960 5.6920
4/16/99 13.8610 5.7870
4/23/99 13.3110 5.8180
4/30/99 12.8540 5.8950
5/7/99 12.7490 6.0400
5/14/99 13.1710 6.1010
5/21/99 14.4320 5.9940
5/28/99 14.4880 6.0500
6/4/99 14.1090 6.1650
6/11/99 14.7710 6.3660
6/18/99 13.6310 6.2100
6/25/99 14.7150 6.3880
7/2/99 14.2710 6.1970
7/9/99 14.2180 6.2050
7/16/99 14.6040 6.0770
7/23/99 14.9740 6.2170
7/30/99 14.8340 6.2960
8/6/99 15.4390 6.3700
8/13/99 14.9540 6.3760
8/20/99 15.1950 6.2850
8/27/99 15.0040 6.2640
9/3/99 15.1990 6.3280
9/10/99 14.5030 6.3490
9/17/99 14.5020 6.3610
9/24/99 14.1750 6.2460
10/1/99 14.3350 6.4570
10/8/99 14.3890 6.4850
10/15/99 14.6110 6.5430
10/22/99 14.1730 6.6330
10/29/99 13.8610 6.3950
11/5/99 13.8100 6.2970
11/12/99 13.5810 6.2660
11/19/99 13.7590 6.3810
11/26/99 13.7700 6.4550
12/3/99 14.3890 6.4750
12/10/99 14.3670 6.3700
12/17/99 14.3240 6.6130
12/23/99 14.3900 6.6960
12/31/99 14.0960 6.6920
1/7/00 14.2830 6.7010
1/14/00 14.2840 6.8100
1/21/00 14.0720 6.8230
1/28/00 14.5830 6.5420
2/4/00 14.3300 6.4000
2/11/00 14.2880 6.4960
2/18/00 14.0980 6.3460
2/25/00 13.9750 6.3550
3/3/00 13.8220 6.3010
3/10/00 13.6740 6.3780
3/17/00 13.8230 6.1950
3/24/00 14.0490 6.2060
3/31/00 14.1860 6.0600
4/7/00 14.2920 5.9240
4/14/00 14.5670 6.0460
4/20/00 14.5780 6.0770
4/28/00 14.5890 6.2060
5/5/00 15.8410 6.4680
5/12/00 15.9070 6.4840
5/19/00 15.6450 6.4970
5/26/00 15.4860 6.3300
6/2/00 14.3460 6.2050
6/9/00 14.1850 6.1470
6/16/00 14.1860 6.1220
6/23/00 14.4020 6.2850
6/30/00 14.2940 6.1550
7/7/00 14.0820 6.1310
7/14/00 13.9790 6.1340
7/21/00 13.8770 6.0320
7/28/00 14.0850 6.0190
8/4/00 13.7480 5.9380
8/11/00 13.6300 5.9410
8/18/00 13.8820 5.9030
8/25/00 13.8320 5.8830
9/1/00 13.6830 5.8670
9/8/00 13.4400 5.9080
9/15/00 13.7850 6.0890
9/22/00 13.9880 6.0960
9/29/00 13.8550 6.0580
10/6/00 13.7830 6.0320
10/13/00 14.1440 5.9920
10/20/00 14.5230 5.9060
10/27/00 14.5230 5.9180
11/3/00 14.2820 6.0350
11/10/00 14.3580 6.0230
11/17/00 14.1970 5.9190
11/24/00 14.0910 5.8240
12/1/00 14.1970 5.7800
12/8/00 14.4690 5.6750
12/15/00 14.7500 5.5590
12/22/00 14.5250 5.5140
12/29/00 14.6380 5.5830
1/5/01 14.0940 5.5200
1/12/01 14.0750 5.7400
1/19/01 13.8690 5.6590
1/26/01 13.7390 5.7430
2/2/01 13.5420 5.6010
2/9/01 13.3890 5.5690
2/16/01 13.4190 5.6690
2/23/01 13.6340 5.6780
3/2/01 13.4030 5.5610
3/9/01 13.2720 5.5080
3/16/01 13.5690 5.4360
3/23/01 13.8980 5.4660
3/30/01 13.6470 5.6300
4/6/01 13.4990 5.6030
4/12/01 13.4220 5.7760
4/20/01 13.6750 5.9230
4/27/01 13.4890 5.9340
5/4/01 13.3930 5.7730
5/11/01 13.4700 6.0260
5/18/01 13.3550 5.9140
5/25/01 13.4220 6.0190
6/1/01 13.5780 5.8730
6/8/01 13.3000 5.8920
6/15/01 13.3090 5.8300
6/22/01 13.4050 5.7150
6/29/01 13.5600 5.8990
7/6/01 13.6690 5.8980
7/13/01 14.1620 5.7850
7/20/01 13.6910 5.6860
7/27/01 13.8020 5.6740
8/3/01 13.7530 5.7010
8/10/01 13.6050 5.6310
8/17/01 13.8060 5.5400
8/24/01 13.8070 5.5560
8/31/01 13.6290 5.4750
9/7/01 13.7500 5.4860
9/14/01 13.9640 5.4480
9/21/01 13.8610 5.6660
9/28/01 14.0670 5.4960
10/5/01 14.2680 5.4040
10/12/01 14.3860 5.5180
10/19/01 14.1390 5.4470
10/26/01 14.1710 5.3460
11/2/01 14.3320 5.1630
11/9/01 14.2240 5.0740
11/16/01 14.6070 5.5220
11/23/01 14.3540 5.6300
11/30/01 14.3320 5.5560
12/7/01 14.2790 5.9000
12/14/01 14.4640 5.8840
12/21/01 15.0370 5.7650
12/28/01 14.8960 5.8310
1/4/02 14.5550 5.8600
1/11/02 14.8400 5.6110
1/18/02 14.9230 5.6060
1/25/02 15.1980 5.7330
2/1/02 15.5580 5.6440
2/8/02 15.8960 5.6230
2/15/02 14.6190 5.6030
2/22/02 14.4210 5.5770
3/1/02 14.0490 5.7100
3/8/02 13.8760 5.9520
3/15/02 13.5760 5.9910
3/22/02 13.8040 6.0340
3/28/02 13.6940 6.0370
4/5/02 13.8750 5.8540
4/12/02 12.2390 5.8370
4/19/02 13.4300 5.8720
4/26/02 13.4680 5.7550
5/3/02 13.2680 5.7240
5/10/02 13.3340 5.7820
5/17/02 13.2410 5.9310
5/24/02 13.3920 5.8410
5/31/02 13.6940 5.7890
6/7/02 14.0820 5.8240
6/14/02 14.0310 5.5900
6/21/02 15.0890 5.5790
6/28/02 14.5480 5.6900
7/5/02 15.0910 5.7030
7/12/02 14.9150 5.5140
7/19/02 14.9390 5.5310
7/26/02 15.0350 5.4870
8/2/02 14.6890 5.3600
8/9/02 14.3580 5.2950
8/16/02 14.1450 5.2770
8/23/02 13.8370 5.2020
8/30/02 13.6380 5.1290
9/6/02 13.5420 5.0650
9/13/02 13.6900 4.9420
9/20/02 13.9940 4.8970
9/27/02 14.0870 4.8580
10/4/02 13.9620 4.8860
10/11/02 13.6390 4.9830
10/18/02 13.7580 5.2610
10/25/02 13.5310 5.2500
11/1/02 13.5800 5.1670
11/8/02 13.6150 4.9530
11/15/02 13.5420 5.0940
11/22/02 13.1810 5.1860
11/29/02 13.1860 5.2330
12/6/02 13.0710 5.1540
12/13/02 13.5430 5.1110
12/20/02 13.8170 5.0620
12/27/02 13.9190 4.9390
1/3/03 14.6450 5.1240
1/10/03 15.1690 5.2250
1/17/03 15.4150 5.0860
1/24/03 15.4540 4.9950
1/31/03 14.8550 5.0070
2/7/03 14.9960 4.9520
2/14/03 15.4710 5.0290
2/21/03 15.2640 4.9800
2/28/03 15.3520 4.7920
3/7/03 15.1840 4.7680
3/14/03 14.7270 4.8250
3/21/03 15.0050 5.1630
3/28/03 15.5530 5.0280
4/4/03 15.1230 5.0690
4/11/03 15.0510 5.0580
4/17/03 14.2200 4.9990
4/25/03 14.6690 4.9290
5/2/03 14.4360 4.9290
5/9/03 14.0830 4.7580
5/16/03 13.7550 4.5110
5/23/03 13.3850 4.3390
5/30/03 13.1780 4.4450
6/6/03 12.6430 4.4630
6/13/03 12.2660 4.2280
6/20/03 12.5580 4.5170
6/27/03 12.8630 4.6630
7/3/03 12.6630 4.7330
7/11/03 12.6460 4.7350
7/18/03 12.3930 4.9890
7/25/03 12.4190 5.1910
8/1/03 12.7360 5.4490
8/8/03 12.8430 5.3470
8/15/03 12.6950 5.5330
8/22/03 12.3320 5.3920
8/29/03 12.3670 5.3560
9/5/03 12.3180 5.3390
9/12/03 12.2940 5.2740
9/19/03 12.1080 5.1700
9/26/03 12.0840 5.0450
10/3/03 12.1480 5.2090
10/10/03 11.7940 5.2720
10/17/03 11.8330 5.3650
10/24/03 11.8020 5.2030
10/31/03 11.6130 5.2470
11/7/03 11.5170 5.3680
11/14/03 11.3650 5.1610
11/21/03 11.3360 5.1060
11/28/03 11.2940 5.2440
12/5/03 10.6100 5.1440
12/12/03 10.4510 5.1850
12/19/03 10.2350 5.0570
12/26/03 10.2660 5.0640
1/2/04 10.2350 5.2840
1/9/04 9.8970 5.0490
1/16/04 10.3590 4.9630
1/23/04 10.3290 5.0230
1/30/04 10.5300 5.0530
2/6/04 10.3920 5.0090
2/13/04 10.5190 4.9900
2/20/04 10.9800 5.0220
2/27/04 11.2030 4.9160
3/5/04 10.9690 4.7900
3/12/04 10.6890 4.7450
3/19/04 10.4770 4.7590
3/26/04 10.4580 4.8230
4/2/04 10.7150 5.0560
4/8/04 10.5210 5.1230
4/16/04 10.9140 5.2710
4/23/04 11.0510 5.3350

Yields

0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0
0 0

Exhibit 2. US and Venezuelan Dollar-Denominated Government Yields

Yields2

1/2/98 1/30/98 2/27/98 3/27/98 4/24/98 5/22/98 6/19/98 7/17/98 8/14/98 9/11/98 10/9/98 11/6/98 12/4/98 12/31/98 1/29/99 2/26/99 3/26/99 4/23/99 5/21/99 6/18/99 7/16/99 8/13/99 9/10/99 10/8/99 11/5/99 12/3/99 12/31/99 1/28/00 2/25/00 3/24/00 4/20/00 5/19/00 6/16/00 7/14/00 8/11/00 9/8/00 10/6/00 11/3/00 12/1/00 12/29/00 1/26/01 2/23/01 3/23/01 4/20/01 5/18/01 6/15/01 7/13/01 8/10/01 9/7/01 9/14/01 10/12/01 11/9/01 12/7/01 1/4/02 2/1/02 3/1/02 3/28/02 4/26/02 5/24/02 6/21/02 7/19/02 8/16/02 9/13/02 10/11/02 11/8/02 12/6/02 1/3/03 1/31/03 2/28/03 3/28/03 4/25/03 5/23/03 6/20/03 7/18/03 8/15/03 9/12/03 10/10/03 11/7/03 12/5/03 1/2/04 1/30/04 2/27/04 3/26/04 4/23/04
10.3700 10.6000 10.5000 10.1390 10.5510 10.9010 11.4850 12.3560 15.8060 23.3280 14.5900 14.8170 16.7840 15.2980 16.3580 16.4010 16.2960 13.3110 14.4320 13.6310 14.6040 14.9540 14.5030 14.3890 13.8100 14.3890 14.0960 14.5830 13.9750 14.0490 14.5780 15.6450 14.1860 13.9790 13.6300 13.4400 13.7830 14.2820 14.1970 14.6380 13.7390 13.6340 13.8980 13.6750 13.3550 13.3090 14.1620 13.6050 13.7500 13.9640 14.3860 14.2240 14.2790 14.5550 15.5580 14.0490 13.6940 13.4680 13.3920 15.0890 14.9390 14.1450 13.6900 13.6390 13.6150 13.0710 14.6450 14.8550 15.3520 15.5530 14.6690 13.3850 12.5580 12.3930 12.6950 12.2940 11.7940 11.5170 10.6100 10.2350 10.5300 11.2030 10.4580 11.0510
5.8990 5.8460 5.9460 5.9810 5.9780 5.9540 5.7400 5.7980 5.6340 5.3560 5.4090 5.5790 5.2980 5.3510 5.3030 5.7780 5.8360 5.8180 5.9940 6.2100 6.0770 6.3760 6.3490 6.4850 6.2970 6.4750 6.6920 6.5420 6.3550 6.2060 6.0770 6.4970 6.1220 6.1340 5.9410 5.9080 6.0320 6.0350 5.7800 5.5830 5.7430 5.6780 5.4660 5.9230 5.9140 5.8300 5.7850 5.6310 5.4860 5.4480 5.5180 5.0740 5.9000 5.8600 5.6440 5.7100 6.0370 5.7550 5.8410 5.5790 5.5310 5.2770 4.9420 4.9830 4.9530 5.1540 5.1240 5.0070 4.7920 5.0280 4.9290 4.3390 4.5170 4.9890 5.5330 5.2740 5.2720 5.3680 5.1440 5.2840 5.0530 4.9160 4.8230 5.3350

Date Vz Debt Yield US Treasury
1/2/98 10.3700 5.8990
1/30/98 10.6000 5.8460
2/27/98 10.5000 5.9460
3/27/98 10.1390 5.9810
4/24/98 10.5510 5.9780
5/22/98 10.9010 5.9540
6/19/98 11.4850 5.7400
7/17/98 12.3560 5.7980
8/14/98 15.8060 5.6340
9/11/98 23.3280 5.3560
10/9/98 14.5900 5.4090
11/6/98 14.8170 5.5790
12/4/98 16.7840 5.2980
12/31/98 15.2980 5.3510
1/29/99 16.3580 5.3030
2/26/99 16.4010 5.7780
3/26/99 16.2960 5.8360
4/23/99 13.3110 5.8180
5/21/99 14.4320 5.9940
6/18/99 13.6310 6.2100
7/16/99 14.6040 6.0770
8/13/99 14.9540 6.3760
9/10/99 14.5030 6.3490
10/8/99 14.3890 6.4850
11/5/99 13.8100 6.2970
12/3/99 14.3890 6.4750
12/31/99 14.0960 6.6920
1/28/00 14.5830 6.5420
2/25/00 13.9750 6.3550
3/24/00 14.0490 6.2060
4/20/00 14.5780 6.0770
5/19/00 15.6450 6.4970
6/16/00 14.1860 6.1220
7/14/00 13.9790 6.1340
8/11/00 13.6300 5.9410
9/8/00 13.4400 5.9080
10/6/00 13.7830 6.0320
11/3/00 14.2820 6.0350
12/1/00 14.1970 5.7800
12/29/00 14.6380 5.5830
1/26/01 13.7390 5.7430
2/23/01 13.6340 5.6780
3/23/01 13.8980 5.4660
4/20/01 13.6750 5.9230
5/18/01 13.3550 5.9140
6/15/01 13.3090 5.8300
7/13/01 14.1620 5.7850
8/10/01 13.6050 5.6310
9/7/01 13.7500 5.4860
9/14/01 13.9640 5.4480
10/12/01 14.3860 5.5180
11/9/01 14.2240 5.0740
12/7/01 14.2790 5.9000
1/4/02 14.5550 5.8600
2/1/02 15.5580 5.6440
3/1/02 14.0490 5.7100
3/28/02 13.6940 6.0370
4/26/02 13.4680 5.7550
5/24/02 13.3920 5.8410
6/21/02 15.0890 5.5790
7/19/02 14.9390 5.5310
8/16/02 14.1450 5.2770
9/13/02 13.6900 4.9420
10/11/02 13.6390 4.9830
11/8/02 13.6150 4.9530
12/6/02 13.0710 5.1540
1/3/03 14.6450 5.1240
1/31/03 14.8550 5.0070
2/28/03 15.3520 4.7920
3/28/03 15.5530 5.0280
4/25/03 14.6690 4.9290
5/23/03 13.3850 4.3390
6/20/03 12.5580 4.5170
7/18/03 12.3930 4.9890
8/15/03 12.6950 5.5330
9/12/03 12.2940 5.2740
10/10/03 11.7940 5.2720
11/7/03 11.5170 5.3680
12/5/03 10.6100 5.1440
1/2/04 10.2350 5.2840
1/30/04 10.5300 5.0530
2/27/04 11.2030 4.9160
3/26/04 10.4580 4.8230
4/23/04 11.0510 5.3350

US Treasury Yield
Venezuelan Government Debt Yield

Sheet2

4-Jan-02 11-Jan-02 18-Jan-02 25-Jan-02 1-Feb-02 8-Feb-02 15-Feb-02 22-Feb-02 1-Mar-02 8-Mar-02 15-Mar-02 22-Mar-02 29-Mar-02 5-Apr-02 12-Apr-02 19-Apr-02 26-Apr-02 3-May-02 10-May-02 17-May-02 24-May-02 31-May-02 7-Jun-02 14-Jun-02 21-Jun-02 28-Jun-02 5-Jul-02 12-Jul-02 19-Jul-02 26-Jul-02 2-Aug-02 9-Aug-02 16-Aug-02 23-Aug-02 30-Aug-02 6-Sep-02 13-Sep-02 20-Sep-02 27-Sep-02 4-Oct-02 11-Oct-02 18-Oct-02 25-Oct-02 1-Nov-02 8-Nov-02 15-Nov-02 22-Nov-02 29-Nov-02 6-Dec-02 13-Dec-02 20-Dec-02 27-Dec-02 3-Jan-03 10-Jan-03 17-Jan-03 24-Jan-03 31-Jan-03 7-Feb-03 14-Feb-03 21-Feb-03 28-Feb-03 7-Mar-03 14-Mar-03 21-Mar-03 28-Mar-03 4-Apr-03 11-Apr-03 18-Apr-03 25-Apr-03 2-May-03 9-May-03 16-May-03 23-May-03 30-May-03 6-Jun-03 13-Jun-03 20-Jun-03 27-Jun-03 4-Jul-03 11-Jul-03 18-Jul-03 25-Jul-03 1-Aug-03 8-Aug-03 15-Aug-03 22-Aug-03 29-Aug-03 5-Sep-03 12-Sep-03 19-Sep-03 26-Sep-03 3-Oct-03 10-Oct-03 17-Oct-03 24-Oct-03 31-Oct-03 7-Nov-03 14-Nov-03 21-Nov-03 28-Nov-03 5-Dec-03 12-Dec-03 19-Dec-03 26-Dec-03 2-Jan-04 9-Jan-04 16-Jan-04 23-Jan-04 30-Jan-04 6-Feb-04 13-Feb-04 20-Feb-04 27-Feb-04 5-Mar-04 12-Mar-04 19-Mar-04
15 15.25 15.68 15.82 15.9 13.99 15.92 15.3 15.86 14.2 13.69 13.49 13.8 13.8 19.2 14 14.6 14.55 14.8 16.55 17.3 16.12 15.7 15.45 13.85 14.23 13.44 13.85 13.4 12.2 12.67 10.86 11.48 11.65 11 11.6 11.37 10.72 10.53 10.41 11.6 11.9 11.95 12.05 11.91 12.05 12.93 13.08 13.55 14.18 13.74 14.15 12.88 11.8 12 10.9 10.28 9.7 9.45 10.08 10.13 9.84 9.7 9.43 8.96 9.31 8.7 9.61 9.75 10.56 10.5 10.45 10.84 12.73 12.32 12.94 13 12.75 12.59 12.25 12.04 12.5 12.62 12.71 12.7 12.85 13.23 14.18 14.11 14.1 13.65 14.1 14.59 14.18 14.5 14.96 16.43 15.87 15.25 15.9 16.62 15.1 14.93 15.08 15.6 16.97 17.37 19.1 18.28 18.84 18.55 18.5 18.53 19 18.2 18.47
1700 1625 1700 1720 1750 1675 2050 2350 2260 1900 1800 1700 1705 1715.25 2106 1750 1705 1700 1925 2300 2410 2500 2535 2585 2500 2630 2400 2500 2475 2210 2345 2200 2200 2265 2150 2300 2375 2230 2150 2250 2400 2325 2350 2425 2306 2300 2410 2465 2465 2465 2465 2465 2465 2465 2465 2465 2650 2425 2290 2401 2360 2300 2500 2400 2329 2426 2300 2280 2300 2420 2400 2630 3100 4050 4225 4515 4750 4715 4700 4949 4815 4302 4530 4500 4712.5 4700 4719 5060 5000 5010 4900 5030 5200 5300 5360 5800 6080 5630 5700 5836 6405 6550 6000 6300 6325 7005 7652 8120 7906 7945 8000 8400 8600 9300 8851 8650
793 746 759 761 770 838 901 1075 997 937 920 882 865 870 768 875 817 818 910 973 975 1086 1130 1171 1264 1294 1250 1264 1293 1268 1296 1418 1341 1361 1368 1388 1462 1456 1429 1513 1448 1368 1377 1409 1355 1336 1305 1319 1273 1217 1256 1219 1340 1462 1438 1583 1804 1750 1696 1667 1631 1636 1804 1782 1820 1824 1851 1661 1651 1604 1600 1762 2002 2227 2401 2442 2558 2589 2613 2828 2799 2409 2513 2478 2597 2560 2497 2498 2481 2487 2513 2497 2495 2616 2588 2714 2590 2483 2616 2569 2698 3036 2813 2924 2838 2890 3084 2976 3027 2952 3019 3178 3249 3426 3404 3278
760.35 761.66 763.1 763.49 767.34 794.33 905.63 1070.72 1000.75 935.46 922.51 890.79 920.57 905.52 850.46 841.49 840.43 886.57 955.58 1001.56 1002.48 1125.65 1150.38 1192.31 1270.22 1349.96 1285.99 1288.05 1272.54 1319.88 1345.93 1360.12 1367.31 1401.62 1412.05 1442.25 1464.17 1467.35 1471.74 1488.52 1482.09 1413.76 1433.94 1425.07 1371.08 1351.54 1331.26 1325.49 1316.82 1296.92 1331.39 1385.51 1406.19 1491.82 1779.14 1921.85 1920.85 1920.59 1598.73 1598.09 1597.31 1597.16 1597.2 1597.75 1597.17 1598.16 1598.68 1598.24 1598.68 1598.1 1597.13 1598.48 1598.02 1597.67 1598.59 1598.2 1597.18 1598.22 1598.22 1598.26 1598.41 1598.61 1597.71 1598.05 1598.15 1598.53 1597.57 1598.02 1597.89 1598.1 1597.41 1597.39 1598.66 1597.57 1597.67 1597.69 1598.67 1597.79 1597.92 1597.66 1598.65 1597.82 1598.69 1598.41 1598.52 1598.49 1598.28 1597.93 1598.07 1597.47 1916.92 1917.26 1917.17 1916.57 1918.94 1917.86

4-Jan-02 11-Jan-02 18-Jan-02 25-Jan-02 1-Feb-02 8-Feb-02 15-Feb-02 22-Feb-02 1-Mar-02 8-Mar-02 15-Mar-02 22-Mar-02 29-Mar-02 5-Apr-02 12-Apr-02 19-Apr-02 26-Apr-02 3-May-02 10-May-02 17-May-02 24-May-02 31-May-02 7-Jun-02 14-Jun-02 21-Jun-02 28-Jun-02 5-Jul-02 12-Jul-02 19-Jul-02 26-Jul-02 2-Aug-02 9-Aug-02 16-Aug-02 23-Aug-02 30-Aug-02 6-Sep-02 13-Sep-02 20-Sep-02 27-Sep-02 4-Oct-02 11-Oct-02 18-Oct-02 25-Oct-02 1-Nov-02 8-Nov-02 15-Nov-02 22-Nov-02 29-Nov-02 6-Dec-02 13-Dec-02 20-Dec-02 27-Dec-02 3-Jan-03 10-Jan-03 17-Jan-03 24-Jan-03 31-Jan-03 7-Feb-03 14-Feb-03 21-Feb-03 28-Feb-03 7-Mar-03 14-Mar-03 21-Mar-03 28-Mar-03 4-Apr-03 11-Apr-03 18-Apr-03 25-Apr-03 2-May-03 9-May-03 16-May-03 23-May-03 30-May-03 6-Jun-03 13-Jun-03 20-Jun-03 27-Jun-03 4-Jul-03 11-Jul-03 18-Jul-03 25-Jul-03 1-Aug-03 8-Aug-03 15-Aug-03 22-Aug-03 29-Aug-03 5-Sep-03 12-Sep-03 19-Sep-03 26-Sep-03 3-Oct-03 10-Oct-03 17-Oct-03 24-Oct-03 31-Oct-03 7-Nov-03 14-Nov-03 21-Nov-03 28-Nov-03 5-Dec-03 12-Dec-03 19-Dec-03 26-Dec-03 2-Jan-04 9-Jan-04 16-Jan-04 23-Jan-04 30-Jan-04 6-Feb-04 13-Feb-04 20-Feb-04 27-Feb-04 5-Mar-04 12-Mar-04 19-Mar-04
793.33 745.90 758.93 761.06 770.44 838.10 901.38 1,075.16 997.48 936.62 920.38 882.13 864.86 870.05 767.81 875.00 817.47 817.87 910.47 972.81 975.14 1,085.61 1,130.25 1,171.20 1,263.54 1,293.75 1,250.00 1,263.54 1,292.91 1,268.03 1,295.58 1,418.05 1,341.46 1,360.94 1,368.18 1,387.93 1,462.18 1,456.16 1,429.25 1,512.97 1,448.28 1,367.65 1,376.57 1,408.71 1,355.33 1,336.10 1,304.72 1,319.19 1,273.43 1,216.85 1,255.82 1,219.43 1,339.67 1,462.29 1,437.92 1,583.03 1,804.47 1,750.00 1,696.30 1,667.36 1,630.80 1,636.18 1,804.12 1,781.55 1,819.53 1,824.06 1,850.57 1,660.77 1,651.28 1,604.17 1,600.00 1,761.72 2,001.85 2,227.02 2,400.57 2,442.43 2,557.69 2,588.63 2,613.19 2,828.00 2,799.42 2,409.12 2,512.68 2,478.36 2,597.44 2,560.31 2,496.83 2,497.88 2,480.51 2,487.23 2,512.82 2,497.16 2,494.86 2,616.36 2,587.59 2,713.90 2,590.38 2,483.30 2,616.39 2,569.31 2,697.65 3,036.42 2,813.13 2,924.40 2,838.14 2,889.51 3,083.71 2,975.92 3,027.46 2,951.96 3,018.87 3,178.38 3,248.79 3,426.32 3,404.23 3,278.29
760.35 761.66 763.10 763.49 767.34 794.33 905.63 1,070.72 1,000.75 935.46 922.51 890.79 920.57 905.52 850.46 841.49 840.43 886.57 955.58 1,001.56 1,002.48 1,125.65 1,150.38 1,192.31 1,270.22 1,349.96 1,285.99 1,288.05 1,272.54 1,319.88 1,345.93 1,360.12 1,367.31 1,401.62 1,412.05 1,442.25 1,464.17 1,467.35 1,471.74 1,488.52 1,482.09 1,413.76 1,433.94 1,425.07 1,371.08 1,351.54 1,331.26 1,325.49 1,316.82 1,296.92 1,331.39 1,385.51 1,406.19 1,491.82 1,779.14 1,921.85 1,920.85 1,920.59 1,598.73 1,598.09 1,597.31 1,597.16 1,597.20 1,597.75 1,597.17 1,598.16 1,598.68 1,598.24 1,598.68 1,598.10 1,597.13 1,598.48 1,598.02 1,597.67 1,598.59 1,598.20 1,597.18 1,598.22 1,598.22 1,598.26 1,598.41 1,598.61 1,597.71 1,598.05 1,598.15 1,598.53 1,597.57 1,598.02 1,597.89 1,598.10 1,597.41 1,597.39 1,598.66 1,597.57 1,597.67 1,597.69 1,598.67 1,597.79 1,597.92 1,597.66 1,598.65 1,597.82 1,598.69 1,598.41 1,598.52 1,598.49 1,598.28 1,597.93 1,598.07 1,597.47 1,916.92 1,917.26 1,917.17 1,916.57 1,918.94 1,917.86

Date US price of VNT Price of TDV.D Implicit rate Official rate
4-Jan-02 15 1700 793 760.35
11-Jan-02 15.25 1625 746 761.66
18-Jan-02 15.68 1700 759 763.1
25-Jan-02 15.82 1720 761 763.49
1-Feb-02 15.9 1750 770 767.34
8-Feb-02 13.99 1675 838 794.33
15-Feb-02 15.92 2050 901 905.63
22-Feb-02 15.3 2350 1075 1070.72
1-Mar-02 15.86 2260 997 1000.75
8-Mar-02 14.2 1900 937 935.46
15-Mar-02 13.69 1800 920 922.51
22-Mar-02 13.49 1700 882 890.79
29-Mar-02 13.8 1705 865 920.57
5-Apr-02 13.8 1715.25 870 905.52
12-Apr-02 19.2 2106 768 850.46
19-Apr-02 14 1750 875 841.49
26-Apr-02 14.6 1705 817 840.43
3-May-02 14.55 1700 818 886.57
10-May-02 14.8 1925 910 955.58
17-May-02 16.55 2300 973 1001.56
24-May-02 17.3 2410 975 1002.48
31-May-02 16.12 2500 1086 1125.65
7-Jun-02 15.7 2535 1130 1150.38
14-Jun-02 15.45 2585 1171 1192.31
21-Jun-02 13.85 2500 1264 1270.22
28-Jun-02 14.23 2630 1294 1349.96
5-Jul-02 13.44 2400 1250 1285.99
12-Jul-02 13.85 2500 1264 1288.05
19-Jul-02 13.4 2475 1293 1272.54
26-Jul-02 12.2 2210 1268 1319.88
2-Aug-02 12.67 2345 1296 1345.93
9-Aug-02 10.86 2200 1418 1360.12
16-Aug-02 11.48 2200 1341 1367.31
23-Aug-02 11.65 2265 1361 1401.62
30-Aug-02 11 2150 1368 1412.05
6-Sep-02 11.6 2300 1388 1442.25
13-Sep-02 11.37 2375 1462 1464.17
20-Sep-02 10.72 2230 1456 1467.35
27-Sep-02 10.53 2150 1429 1471.74
4-Oct-02 10.41 2250 1513 1488.52
11-Oct-02 11.6 2400 1448 1482.09
18-Oct-02 11.9 2325 1368 1413.76
25-Oct-02 11.95 2350 1377 1433.94
1-Nov-02 12.05 2425 1409 1425.07
8-Nov-02 11.91 2306 1355 1371.08
15-Nov-02 12.05 2300 1336 1351.54
22-Nov-02 12.93 2410 1305 1331.26
29-Nov-02 13.08 2465 1319 1325.49
6-Dec-02 13.55 2465 1273 1316.82
13-Dec-02 14.18 2465 1217 1296.92
20-Dec-02 13.74 2465 1256 1331.39
27-Dec-02 14.15 2465 1219 1385.51
3-Jan-03 12.88 2465 1340 1406.19
10-Jan-03 11.8 2465 1462 1491.82
17-Jan-03 12 2465 1438 1779.14
24-Jan-03 10.9 2465 1583 1921.85
31-Jan-03 10.28 2650 1804 1920.85
7-Feb-03 9.7 2425 1750 1920.59
14-Feb-03 9.45 2290 1696 1598.73
21-Feb-03 10.08 2401 1667 1598.09
28-Feb-03 10.13 2360 1631 1597.31
7-Mar-03 9.84 2300 1636 1597.16
14-Mar-03 9.7 2500 1804 1597.2
21-Mar-03 9.43 2400 1782 1597.75
28-Mar-03 8.96 2329 1820 1597.17
4-Apr-03 9.31 2426 1824 1598.16
11-Apr-03 8.7 2300 1851 1598.68
18-Apr-03 9.61 2280 1661 1598.24
25-Apr-03 9.75 2300 1651 1598.68
2-May-03 10.56 2420 1604 1598.1
9-May-03 10.5 2400 1600 1597.13
16-May-03 10.45 2630 1762 1598.48
23-May-03 10.84 3100 2002 1598.02
30-May-03 12.73 4050 2227 1597.67
6-Jun-03 12.32 4225 2401 1598.59
13-Jun-03 12.94 4515 2442 1598.2
20-Jun-03 13 4750 2558 1597.18
27-Jun-03 12.75 4715 2589 1598.22
4-Jul-03 12.59 4700 2613 1598.22
11-Jul-03 12.25 4949 2828 1598.26
18-Jul-03 12.04 4815 2799 1598.41
25-Jul-03 12.5 4302 2409 1598.61
1-Aug-03 12.62 4530 2513 1597.71 2363
8-Aug-03 12.71 4500 2478 1598.05
15-Aug-03 12.7 4712.5 2597 1598.15
22-Aug-03 12.85 4700 2560 1598.53
29-Aug-03 13.23 4719 2497 1597.57
5-Sep-03 14.18 5060 2498 1598.02
12-Sep-03 14.11 5000 2481 1597.89 2381
19-Sep-03 14.1 5010 2487 1598.1
26-Sep-03 13.65 4900 2513 1597.41
3-Oct-03 14.1 5030 2497 1597.39
10-Oct-03 14.59 5200 2495 1598.66
17-Oct-03 14.18 5300 2616 1597.57
24-Oct-03 14.5 5360 2588 1597.67
31-Oct-03 14.96 5800 2714 1597.69
7-Nov-03 16.43 6080 2590 1598.67
14-Nov-03 15.87 5630 2483 1597.79
21-Nov-03 15.25 5700 2616 1597.92 2436
28-Nov-03 15.9 5836 2569 1597.66
5-Dec-03 16.62 6405 2698 1598.65
12-Dec-03 15.1 6550 3036 1597.82
19-Dec-03 14.93 6000 2813 1598.69
26-Dec-03 15.08 6300 2924 1598.41
2-Jan-04 15.6 6325 2838 1598.52
9-Jan-04 16.97 7005 2890 1598.49 2810
16-Jan-04 17.37 7652 3084 1598.28
23-Jan-04 19.1 8120 2976 1597.93
30-Jan-04 18.28 7906 3027 1598.07
6-Feb-04 18.84 7945 2952 1597.47 3000
13-Feb-04 18.55 8000 3019 1916.92
20-Feb-04 18.5 8400 3178 1917.26 3100
27-Feb-04 18.53 8600 3249 1917.17 3300
5-Mar-04 19 9300 3426 1916.57 3226
12-Mar-04 18.2 8851 3404 1918.94 3500
19-Mar-04 18.47 8650 3278 1917.86

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

Vice President, Product Management: Donna Battista
Acquisitions Editor: Kate Fernandes
Program Manager: Kathryn Dinovo
Team Lead, Project Management: Jeff Holcomb
Project Manager: Meredith Gertz

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
should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system,
or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or
otherwise. For information regarding permissions, request forms, and the appropriate contacts within the
Pearson Education Global Rights and Permissions department, please visit
www.pearsoned.com/permissions/.

www.pearsonhighered.com

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

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.

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.

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.

Chapter 3 The Balance of Payments 13

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.

Chapter 3 The Balance of Payments 19

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).

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?

Chapter 4 Financial Goals and Corporate Governance 23

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.

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.

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:

¥
$=
PS
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
CE 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
Qe
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

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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).

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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.

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.

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.

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.”

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).

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.

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.

Chapter 12 Operating Exposure 65

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.

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.

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.

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.

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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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.

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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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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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.

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.

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 105

© 2016 Pearson Education, Inc.
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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Week 3 – Assignment: Investigate Foreign Exchange Markets

Write a paper about the foreign exchange market that addresses the following:

1. Discuss the functions of the foreign exchange markets. Identify and appraise the primary institutions and organizations comprising the foreign exchange market. Explain the roles that each of these primary institutions and organizations.

2. Describe how foreign exchange rates are quoted. Define the absolute and relative purchasing power parity theories. Analyze the relationship between interest rates and exchange rates. Describe why these theories and relationships are important for the multinational business manager.

3. Evaluate what you feel to be the five most important impacts on exchange rates for forecasting the direction of exchange rates. Explain each of these impacts and defend your choices. Describe why these forecasts are important to a multinational business manager.

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).

Resources:

https://www.worldbank.org/

50 Journal of International Marketing

Foreign Market Entry Timing
Revisited: Trade-Off Between Market
Share Performance and Firm Survival
Janet Y. Murray, Min Ju, and Gerald Yong Gao

ABSTRACT
This study revisits the impact of entry timing on the performance of foreign-invested firms. The authors posit that bal-
ancing between market share performance and firm survival is critical for foreign firms to capitalize on early-mover
advantages. Using a longitudinal data set of 25,513 foreign firms operating in China, the authors find that early entrants
enjoy higher market shares but suffer from lower survival rates than late entrants. In addition, foreign firms’ entry mode
and investment size affect their market shares and survival. The results also provide supporting evidence of the inter-
action effects among entry timing, entry mode, and investment size on foreign firms’ market shares and survival.

Keywords: foreign direct investment, entry timing, entry mode, market share, survival

Entry timing in penetrating foreign markets repre-sents an important concept in international mar-keting literature. Many conceptual and empirical
studies have focused on the notion of entry timing by
investigating the relationship between entry timing and
firm performance (e.g., Lee et al. 2000; Li 1995; Lilien
and Yoon 1990; Mitchell 1991; Parry and Bass 1990;
Robinson 1988; Suarez and Lanzolla 2007; Varadara-
jan, Yadav, and Shankar 2008). However, most of these
studies have focused on entry timing in the context of
domestic markets (Carpenter and Nakamoto 1989;
Lieberman and Montgomery 1988, 1998). It was not
until the mid-1990s that studies began applying the
principles of entry timing and early movers to inter-
national markets, suggesting that the timing of entry is
a critical strategic decision for firms making investments
in foreign markets (Delios and Makino 2003; Pan, Li,
and Tse 1999; Papyrina 2007; Rivoli and Salorio 1996;
Wang, Chen, and Xie 2010).

Early entrants enjoy various advantages (e.g., higher
market shares), but they also suffer from survival disad-
vantages in international markets, encountering greater
risks and higher uncertainties than late entrants (Delios
and Makino 2003; Frynas, Mellahi, and Pigman 2006;
Wang, Chen, and Xie 2010). For example, on entering
the Chinese market in 1979 after the implementation of
the open-door policy, Coca-Cola was one of the first
international consumer companies to capitalize on the
market opportunities. Since then, Coca-Cola has
become committed to the Chinese market by investing
more than US$5 billion there (Coca-Cola 2011). It has
quickly dominated the soft drinks market, holding a
leading position, and has become a major household
name in China. Whirlpool, one of the early entrants to
the Chinese home appliance industry, began investing in
China in 1994 to manufacture washing machines,
microwave ovens, refrigerators, and air conditioners.
However, because of its poor performance resulting
from high industry uncertainty, Whirlpool withdrew its
investment from the joint ventures with Beijing
Snowflake Electric Appliance and Shenzhen Raybo
Company (Pan, Yang, and Sethi 2005).Janet Y. Murray is E. Desmond Lee Professor for Developing Women

Leaders and Entrepreneurs in International Business and Professor of
Marketing (e-mail: murrayjan@umsl.edu), Min Ju is Visiting Assis-
tant Professor of Marketing (e-mail: jum@umsl.edu), and Gerald
Yong Gao is Associate Professor of Marketing (e-mail:
gaogy@umsl.edu), Department of Marketing, University of Missouri–
St. Louis.

Journal of International Marketing
©2012, American Marketing Association
Vol. 20, No. 3, 2012, pp. 50–64
ISSN 1069-0031X (print) 1547-7215 (electronic)

Foreign Market Entry Timing Revisited 51

Thus, although formidable advantages remain for early
entrants, so too does the likelihood of facing high uncer-
tainty. In this sense, there is a trade-off between market
share performance and firm survival for early entrants.
This dilemma represents one of the most challenging
managerial decisions in sustaining a firm’s competitive
advantages in international markets (Boulding and
Christen 2003). Yet little is known about how to bal-
ance this essential trade-off between different perform-
ance indicators (Min, Kalwani, and Robinson 2006;
Wang, Chen, and Xie 2010). Despite researchers’ efforts
in cautioning firms about the negative consequences of
an imbalance between first-mover advantages and early-
entrant survival disadvantages (Delios and Makino
2003; Papyrina 2007), suggestions on how to strike a
balance between these two have been limited.

This study aims to fill these research gaps by examining
whether early entrants in foreign markets achieve supe-
rior performance to late entrants. We focus on the chal-
lenges of balancing market share performance and firm
survival and address two research issues in extant inter-
national marketing literature. First, although in general
previous studies have found strong and consistent sup-
port for the positive effect of entry timing on firm per-
formance (Delios and Makino 2003; Isobe, Makino,
and Montgomery 2000; Pan, Li, and Tse 1999), the
majority of this research focuses primarily on the per-
formance indicator of market share (Lieberman and
Montgomery 1998). However, market share perform-
ance is usually measured at one point in time but is
likely to fluctuate over time (Kerin, Varadarajan, and
Peterson 1992). Therefore, researchers have called for
reducing the dependency on market share effects by
adopting other measures of performance (Cui and Lui
2005). Furthermore, most previous studies are cross-
sectional in nature and therefore fail to examine firm
survival despite its importance in measuring firm per-
formance in international markets. The current study
contributes to entry timing literature by examining
early-entrant advantages and survival disadvantages in a
foreign market from a longitudinal perspective. Specifi-
cally, we examine both firms’ market shares and sur-
vival. Early entrants enjoy higher market shares, but
they also encounter greater risks of business failure.
Thus, it is critical for early entrants to survive in foreign
markets because doing so enables them to enjoy sus-
tainable market performance from their willingness to
take greater risks.

Second, we provide potential strategies for firms to
achieve a better balance between different performance

indicators. The essence of the first-mover advantage–
early-entrant survival disadvantage dilemma is whether
early entrants can successfully deal with high levels of
uncertainties. The key to the dilemma might be early
market entrants’ strategic choices that can enhance their
survival. In this study, we focus on entry mode and
investment size as two such strategic choices that can
potentially enhance firm survival. In other words, we
investigate the impact of entry mode and investment size
on firms’ performance, and we further examine whether
the effect of entry timing on performance is contingent
on foreign firms’ entry mode choices and their initial
investment size.

We test our hypotheses using a sample of 25,513 foreign
firms that have made foreign direct investments (FDIs)
in China. As the world’s fastest-growing consumer mar-
ket, China has begun attracting enormous FDI inflows.
China began allowing foreign firms to enter the country
in 1979, which provides a starting point for measuring
entry timing of foreign firms. In the past decade, the
inflow of FDI into China has increased from US$45 bil-
lion in 1997 to US$92.4 billion in 2008 (United Nations
Conference on Trade and Development 2009). Thus, the
Chinese market provides an excellent research context
to address our research questions. We trace the perform-
ance and survival of foreign firms operating in multiple
product sectors over a five-year period (1998–2002).
The empirical results provide supportive evidence for
our predictions.

THEORETICAL FOUNDATION
First-Mover Advantage Theory

The concept of first-mover advantages has attracted
much attention in the marketing literature. Lieberman
and Montgomery (1988, p. 41) define first-mover advan-
tages as “the ability of pioneering firms to earn positive
economic profits.” They contend that first-mover advan-
tages arise from three primary sources: technological
leadership, preemption of assets, and the creation of
buyer switching costs. Specifically, first movers can gain
advantages through the learning curve effect and succeed
in the patent or research-and-development race. They
are also able to gain advantages by preempting rivals in
acquiring scarce assets and geographic locations and
creating buyer switching costs. Moreover, researchers
have argued that first movers often enjoy a higher level
of consumer preferences (Carpenter and Nakamoto
1989, 1994; Magnusson, Westjohn, and Boggs 2009).
Therefore, early market entry provides a firm with the

52 Journal of International Marketing

opportunity to gain a larger market share (Mitchell
1991; Robinson, Fornell, and Sullivan 1992). Neverthe-
less, these advantages may not be sufficient for first
movers to keep a strong position as the market evolves,
because they could be overtaken by late movers as a
result of high levels of uncertainties, free-rider effects,
imitation, and shifts in technology (Lieberman and
Montgomery 1988).

Furthermore, empirical evidence related to first-mover
advantages mainly comes from the context of domestic
markets. In foreign markets, risks and uncertainties are
much higher than those in the home market. The uncer-
tainties stem not only from the general costs of doing
business overseas but also from different cultural and
institutional settings (Zaheer 1995). Therefore, the
sources and mechanisms of early-mover advantages may
differ in the context of international markets. On the
one hand, although a foreign firm is an early entrant to
a host market, the market may already be occupied by
local competitors, reducing the magnitude of early-
entrant advantages and increasing the value of the
“wait-and-see” option. On the other hand, local govern-
ments often treat early foreign entrants more favorably
to attract more FDIs, which in turn amplifies early-
entrant advantages.

In recent years, researchers have integrated FDI and
first-mover advantages by examining whether first-
mover advantages can apply to the international market
context (e.g., Delios and Makino 2003; Gao and Pan
2010; Isobe, Makino, and Montgomery 2000; Luo
1998; Pan, Li, and Tse 1999). For example, Cui and Lui
(2005) examine the trade-off between market share and
profitability and conclude that early entrants have a
larger market share while late entrants have a marginal
advantage in profitability. Using a sample of 6955 for-
eign entries of 703 Japanese firms, Delios and Makino
(2003) find that early entrants have a larger investment
size while late entrants have greater chances of survival.
Magnusson, Westjohn, and Boggs’s (2009) findings sup-
port a significant relationship between early entry and
greater market shares for 379 subsidiaries of multi-
national advertising agencies in developing markets. In
general, all these studies have found support for the
positive effect of entry timing on market share as an
indicator of firm performance. Nevertheless, with the
exception of Mitchell’s (1991) work, no study has
specifically examined the trade-off between market
share and firm survival, though research suggests that
firms’ ability to survive is contingent on the timing of
market entry (Gaur and Lu 2007; Golder and Tellis

1993; Wang, Chen, and Xie 2010). Focusing on the U.S.
diagnostic imaging industry, Mitchell (1991) tests the
dual-clock entry order effects on performance and finds
entry timing trade-offs between market share and sur-
vival. Moreover, rather than examining the trade-off
between different performance indicators, Mitchell,
Shaver, and Yeung (1994) investigate the impact of for-
eign market share on firms’ survival rates. They find a
nonmonotonic relationship between the success of inter-
national market entry and the foreign presence in an
industry at the time of entry and conclude that foreign
entrants survive longer in product markets with a mod-
erate number of foreign players. However, whether the
similar pattern between market share and survival can
be generalized to international market contexts remains
unknown. Thus, it is imperative to examine both mar-
ket share performance and firm survival as the perform-
ance outcomes of early international market entry.

Strategic Choice Perspective

Past studies have suggested that the relationship
between entry timing and performance is more complex
than previously theorized, arguing that the entry timing–
performance relationship may be contingent on other fac-
tors (Cui and Lui 2005; De Castro and Chrisman 1995;
Kerin, Varadarajan, and Peterson 1992; Szymanski, Troy,
and Bharadwaj 1995). Theorists advocating the strategic
choice perspective reject the purely deterministic view of
the behavior of organizations promoted by industrial
organization economists (Hitt and Tyler 1991) and argue
that a firm’s strategic choice plays an important role in
determining its success or failure in the marketplace
(Child 1972, 1997). The most critical choices are those
that aim “to ‘match’ firm strategies with changing envi-
ronmental conditions in order to maintain or improve
competitive positions” (Reger, Duhaime, and Stimpert
1992, p. 190). The strategic choice perspective stresses
that managerial actions, such as selecting the structures
and resource allocations, can affect firm performance
(Child, Chung, and Davies 2003). Furthermore, in ana-
lyzing firm strategy (e.g., entry timing), Child (1972, p.
10) states that researchers “must recognize the exercise of
choice by organizational decision makers. The bounda-
ries between an organization and its environment are
defined in large degree by the kinds of relationships which
its decision makers choose to enter.”

Our study focuses on the contingent reasoning of orga-
nizational strategic choices, two forms of which—entry
mode and investment size—are potentially the most fun-
damental strategic factors in international marketing

Foreign Market Entry Timing Revisited 53

(Cui and Lui 2005; Pan, Li, and Tse 1999). The decision
to market to a foreign country by adopting different entry
modes carries significant strategic importance due to the
inherent benefits and risks of each foreign establishment
and entry mode (Brouthers and Brouthers 2000; Dikova
and Van Witteloostuijn 2007; Woodcock, Beamish, and
Makino 1994). Moreover, investment size represents a
good indication of firms’ strategic resources in foreign
markets and greatly affects firms’ abilities to augment the
advantages associated with early entry and risk reduction
(Cui and Lui 2005; Luo 1997). Therefore, given the dis-
tinctive advantages and disadvantages associated with
modes of entry and different sizes of foreign investment,
it is critical to investigate their moderating effects on the
relationship between entry timing and performance.

HYPOTHESES DEVELOPMENT
Entry Timing

In general, early entrants to a foreign market have
competitive advantages over late entrants. First, early
entrants can preempt key natural and human resources in
the host market (Lieberman and Montgomery 1988). In
turn, these resources provide early entrants with a lead in
developing capabilities and competitive advantages. Pre-
emptive factors also build entry barriers for late entrants
and prevent them from gaining access to markets, suppli-
ers, and customers (Delios and Makino 2003). In addi-
tion, early entrants have more options on selecting geo-
graphic locations, suppliers, and business partners (Lilien
and Yoon 1990). Moreover, early entrants usually benefit
from incentives provided by local governments in terms
of taxes, land, and energy supplies. Second, when
expanding into a new foreign market, it is important for
foreign firms to learn and accumulate knowledge about
the host market to overcome the liability of foreignness
(Zaheer 1995). Foreign firms are usually unfamiliar with
the host market conditions, and customized products
require a considerable amount of local market knowledge
(Dikova and Van Witteloostuijn 2007). To successfully
introduce products or services in a new market, firms
need to develop local market knowledge so that they can
meet the requirements and preferences of local customers
(Cantwell, Glac, and Harding 2004). Early entrants enjoy
the advantage of having more time to learn and acquire
local knowledge than late entrants (Li 1995; Pan, Li, and
Tse 1999). Third, previous studies suggest that customers
have a high level of preferences for and loyalty to early
market entrants (Carpenter and Nakamoto 1989). Thus,
early entrants gain first-mover advantages from high cus-
tomer switching costs and better consumption experi-

ences (De Castro and Chrisman 1995). These arguments
suggest that first-mover advantages exist for foreign mar-
ket entry, resulting in better market positions for early
entrants.

Empirically, previous studies have provided supporting
evidence for the positive effect of entry timing on per-
formance indicators, such as sales growth, profitability,
market share, and establishment of a competitive position
in host markets (e.g., Cui and Lui 2005; Delios and
Makino 2003; Luo 1998; Luo and Peng 1998; Pan, Li,
and Tse 1999). For example, Luo (1998) finds that early
entrants to a foreign market outperform late entrants in
local market expansion, as measured by sales growth.
Pan, Li, and Tse (1999) find that early entrants achieve
higher market shares and profitability. Delios and
Makino (2003) conclude that the earlier the market entry,
the greater is a firm’s subsidiary size relative to that of its
competitors. Therefore, we hypothesize the following:

H1a: Early entrants to a foreign market have
higher market shares than late entrants.

Consistent with the growing emphasis that managers
must consider multiple criteria when evaluating the
long-term potential of their businesses (Eccles 1991), we
complement a firm’s market share performance with its
survival in examining the entry timing–performance
relationship. We also acknowledge that “survival per se
is not necessarily a sign of good performance because
shareholders, employees, and the general economy
sometimes benefit if a business shuts down” (Mitchell
Shaver, and Yeung 1994, p. 557). However, firm sur-
vival is widely recognized as an important indicator of
business performance because exit from a foreign mar-
ket usually indicates a failure of management’s original
goal for the business, though firm exit might also be due
to strategic reasons (e.g., seeking new opportunities in
other markets) (Bane and Neubauer 1981).

Although early entrants to a foreign market enjoy first-
mover advantages, they also face substantial costs and
uncertainties. Uncertainties in a foreign market are
greatest in the early stage of foreign market expansion
(Luo 1998). First, foreign entrants are unfamiliar with
local markets in terms of market demand and market
structure. Therefore, it is important for foreign firms to
learn local market knowledge and use it in conjunction
with their resources to develop competitive advantages
(Cantwell, Glac, and Harding 2004; Nerkar and
Roberts 2004). However, local market knowledge is
usually location specific and not readily accessible to

54 Journal of International Marketing

foreign firms, and successful knowledge acquisition
depends on firms’ familiarity with the host market’s spe-
cific structure (Chang 1995). Early entrants might not
even survive during the long-term process of knowledge
accumulation. In contrast, late entry involves less uncer-
tainty about the marketplace because early entrants’
experience can offer market information to late entrants
(Delios and Makino 2003; Gao et al. 2008).

Second, early entrants encounter the highest level of
institutional uncertainties. Host markets’ institutions
provide the central influential forces of the larger envi-
ronment in constraining the optimality of a firm’s
actions (Dikova and Van Witteloostuijn 2007). When
most developing countries open up their markets for
FDI, they are likely to be in the process of replacing the
old institutional regimes with market economy mecha-
nisms, which require a wide array of far-reaching insti-
tutional reforms (Dikova and Van Witteloostuijn 2007;
Pan, Li, and Tse 1999). The underdeveloped and fast-
transition institutional environments in these markets
likely affect the survival of early entrants and create par-
ticular challenges for firms operating there (Peng 2003;
Shenkar 2006). Therefore, some firms may take a wait-
and-see approach and defer their investments until the
environments become more favorable (Rivoli and Salo-
rio 1996). In doing so, late entrants face fewer uncer-
tainties and risks and reduce the possibility of failure by
obtaining more market information and learning from
the experience of early entrants.

Third, early entrants to a foreign market develop strate-
gies depending on the state of the environment at the
time of entry. Because external environments change
over time, firms’ initial strategies may become less suita-
ble for the changing environment. Meanwhile, firms’
routines may create rigidities that hinder them from
adapting to the changes in the external environments
(Hannan and Freeman 1989). Prior research has argued
that incumbent inertia inhibits early entrants’ ability to
respond to environmental changes, thus reducing the
magnitude of their advantages (Liberman and Mont-
gomery 1988). Therefore, we hypothesize the following:

H1b: Early entrants to a foreign market have lower
survival rates than late entrants.

Entry Mode

In expanding into foreign markets, firms can choose
among a variety of entry modes. In this study, we focus
on three major types of entry modes: contractual joint

ventures, equity joint ventures, and wholly owned sub-
sidiaries. Equity joint ventures and wholly owned sub-
sidiaries are considered equity entry modes (Kumar and
Subramaniam 1997). Contractual joint ventures are one
type of nonequity mode in which local and foreign firms
make contractual partnerships (Tallman and Shenkar
1994). From a cost- and control-based rationale, we
posit that wholly owned subsidiaries have higher market
shares and survival rates than equity joint ventures and
that contractual joint ventures have the lowest market
shares and survival rates for the following reasons: First,
to set up wholly owned subsidiaries, foreign firms tend
to rely on existing capabilities in their home market and
simply copy and transfer what they have done success-
fully to other overseas markets (Hahn and Shaver
2005). Thus, they incur lower new resource-based costs.
Compared with joint ventures, the operational costs
associated with wholly owned subsidiaries are also likely
to be less substantial because foreign investors can avoid
problems from divergent strategic viewpoints, dissimilar
management philosophies, incompatible administrative
routines, and different corporate and national cultures
(Papyrina 2007). Furthermore, foreign firms can avoid
costs of finding an appropriate partner (Nitsch, Beamish,
and Makino 1996). Thus, wholly owned subsidiaries
have a greater chance of surviving and a better opportu-
nity to invest in developing market power.

Second, in wholly owned subsidiaries, foreign firms
have complete control over their foreign operations.
With full responsibility and managerial control, foreign
firms are more likely to extend their competitive and
proprietary assets to the host market (Brouthers 2002;
Davidson and McFetridge 1984). Full ownership mode
also enables firms to reap high potential profits, while
joint ventures may allow firms to obtain only a fraction
of such profits. The importance of control and direct
management has become increasingly salient in fierce
market competition, as wholly owned subsidiaries have
more managerial efficiency than joint ventures. There-
fore, foreign firms are more committed to their wholly
owned operations in a foreign market. With fewer inter-
nal conflicts and greater managerial efficiency, foreign
investors have less reservation to invest in the host mar-
ket and are more likely to penetrate the host market
quickly and gain market share aggressively.

We expect contractual joint ventures to have the lowest
market shares and survival rates among the three types
of entry modes. As a nonequity mode, contractual joint
ventures have low control and do not require high
resource commitment (Anderson and Gatignon 1986).

Foreign Market Entry Timing Revisited 55

Because it is often difficult and costly for foreign firms
to maintain contractual partnerships, contractual joint
ventures generally entail the highest coordination costs.
The hazards resulting from organizational differences,
such as divergent strategic viewpoints, dissimilar man-
agement philosophies, incompatible administrative rou-
tines, and different corporate and national cultures,
divert managerial attention away from other important
market activities and decrease managerial efficiency.
Furthermore, according to the transaction cost perspec-
tive, these hazards cannot be reliably safeguarded with
contracts because of bounded rationality (Papyrina
2007). Therefore, we hypothesize the following:

H2a: Wholly owned subsidiaries have higher mar-
ket shares than equity joint ventures, fol-
lowed by contractual joint ventures.

H2b: Wholly owned subsidiaries have higher sur-
vival rates than equity joint ventures, fol-
lowed by contractual joint ventures.

Investment Size

When entering a foreign market, firms must decide on
the level of resources (e.g., cash, human resources, trans-
fer of technology and other types of assets) to commit to
the new market (Cui and Lui 2005; Magnusson, West-
john, and Boggs 2009). Firm size is considered a useful
and manageable approximation of firm resources.
Larger investment size typically indicates a larger firm
size and higher asset power. Large firms have control of
more resources and are better able to overcome risks to
achieve superior performance (Cohen and Klepper
1996). In the marketing literature, firm size is a com-
monly analyzed business variable that has an impact on
a firm’s survival and performance.

In the context of foreign market entry, foreign firms need
to learn about the local environment to overcome the
liability of foreignness and compete with local firms
(Dikova and Van Witteloostuijn 2007; Zaheer 1995). In
addition, substantial investment is necessary for early
entrants to benefit from the first-mover advantages
because they must integrate these advantages with firm
resources to generate competitive advantages (Cui and
Lui 2005; Isobe, Makino, and Montgomery 2000; Luo
1998). Furthermore, the amount of initial investment cre-
ates the foundation to build capabilities and coalitions in
the new market; thus, it acts as a buffer between the
organization and internal changes or external contingen-
cies. Large firms are in a better position to deal with high

risks and uncertainties in the host market (Magnusson,
Westjohn, and Boggs 2009). In addition, large firms also
have stronger bargaining power to negotiate with the host
country government for better concessions and incen-
tives. Therefore, we expect that foreign-invested firms
with a large investment size can stay in business longer
and achieve better market share performance. Thus:

H3a: Foreign firms with a large investment size
have higher market shares.

H3b: Foreign firms with a large investment size
have higher survival rates.

Interaction Effects

Drawing on the contingency theory, several researchers
have called for studies to address the issue of endoge –
neity, in that firms’ decisions regarding foreign market
entry are relative rather than absolute or random
(Papyrina 2007; Shaver 1998). Our study responds to
this call by examining the interactive effects among
entry timing, entry mode, and investment size on firms’
market shares and survival rates. Because the relation-
ship between entry timing and firms’ performance is
more complex than a simple entry order effect, firms’
strategic choices (i.e., entry modes and investment size)
may exert a moderating effect on the entry timing–
performance relationship. In practice, firms often
address the issues of entry timing and entry mode
simultaneously because these could have a joint effect
on firm performance (Papyrina 2007). In addition,
early entry itself is insufficient for sustaining first-
mover advantages, and the effect of early entry is not
uniform across different investment sizes (Cui and Lui
2005; Isobe, Makino, and Montgomery 2000; Luo
1998). Therefore, we further examine whether inter-
active effects exist among entry timing, entry mode,
and investment size and whether firms’ strategic choices
can help them strike a better balance between market
share performance and firm survival.

Market pioneering only provides opportunities to gain
competitive advantages; therefore, firms must possess cer-
tain expertise and resources to exploit these opportunities
(Kerin, Varadarajan, and Peterson 1992). In deciding on
which entry mode to adopt in penetrating foreign markets,
firms must evaluate factors such as the levels of resources,
control, and risks. As we mentioned previously, contrac-
tual joint ventures are a nonequity entry mode in which
local and foreign firms make contractual partnerships
(Tallman and Shenkar 1994). In addition, they are usually

56 Journal of International Marketing

difficult and costly for foreign firms to maintain. In gen-
eral, foreign firms adopting contractual joint ventures do
not commit high levels of resources. In contrast, wholly
owned subsidiaries have many advantages in areas such as
high managerial control, minimal conflicts of interests,
and avoidance of partner opportunism (Cui and Lui 2005;
Papyrina 2007). Therefore, early entrants with contractual
joint ventures in a foreign market are less likely than
equity joint ventures to fully exploit and realize first-
mover advantages, whereas wholly owned subsidiaries are
in a better position to realize first-mover advantages than
equity joint ventures.

A similar rationale applies to the interactive effect
between entry timing and investment size. Foreign firms
with a large investment size are more likely to take pre-
emptive moves to gain local markets, customers, and
other scarce resources (Lieberman and Montgomery
1998). If early entrants are unwilling to commit sub-
stantial resources in the host market and enter on a
small scale, the first-mover advantages realized will be
correspondingly lower. Therefore, we expect that early
entrants with large initial investments are more capable
of exploiting and realizing first-mover advantages than
small-scale early entrants. Thus:

H4a: Entry mode has a positive moderating effect
on the entry timing–market share relation-
ship, with early entrants as wholly owned
subsidiaries having the highest market shares,
followed by equity joint ventures and then
contractual joint ventures.

H4b: Entry mode has a positive moderating effect
on the entry timing–survival rate relation-
ship, with early entrants as wholly owned
subsidiaries having the highest survival rates,
followed by equity joint ventures and then
contractual joint ventures.

H5a: Investment size has a positive moderating effect
on the entry timing–market share relationship.

H5b: Investment size has a positive moderating effect
on the entry timing–survival rate relationship.

METHODOLOGY
Data

The database comes from the Chinese industrial census
from 1998 to 2002, conducted by the State Statistical

Bureau of China. The census data are accurate and
reliable archival data (Tan and Peng 2003), and they
consist of all manufacturing firms, including both local
and foreign firms, except for extremely small busi-
nesses. The total number of firms in the database from
1998 to 2002 is 165,118, 162,033, 162,885, 166,362,
and 176,514, respectively. The database contains the
following information for each firm: geographic loca-
tion, industry code, firm type, scale, age, number of
employees, and accounting information (e.g., assets,
sales). Furthermore, the firms in the database account
for more than 90% of the total industrial output in
China, as compared with the figures from the China
Statistical Yearbook. Thus, we were able to obtain an
accurate measure of an individual firm’s market share
from the database. In 1979, China began allowing for-
eign firms to enter the country for investment purposes.
Thus, this particular year provides us with an accurate
starting point to observe the timing of foreign entries
into China. According to the Chinese Industry Code
(CIC), there are 610 manufacturing product sectors in
China; by 2002, foreign firms had entered 545 product
sectors.

Dependent Variables

Survival Rates. We measured survival for each firm by
an interval equal to the number of years between 1998
and the year that a firm was delisted from the census
data. In our database, the minimum interval is one year,
and the maximum is four years. To compute the dura-
tion measure, we searched the database to find the first
year the firm did not appear in the census. If an exit was
not clear during the period of study, we coded the inter-
val as right censored.

In the database, each firm is identified by a unique code,
which allowed us to track the firm over time. We
tracked foreign-invested firms in the 1998 census data
set during a five-year (1998–2002) period. To further
ensure the accuracy of firm exits in our database, we
tested the models by deleting exiting firms with high
industry performance and obtained robust results. Our
final sample consists of 25,513 firms, 10,175 (42%) of
which exited during the five-year period. We treated the
remaining 14,798 (58%) firms as right-censored cases.

Market Share. We measured market share as the per-
centage of a foreign firm’s sales to total sales in China in
a four-digit CIC product sector, including all foreign and
local firms. We computed the average market share a
firm attained during the five-year study period. If a firm

Foreign Market Entry Timing Revisited 57

exited during the period, we measured the average mar-
ket share for years of operation.

Independent Variables

Entry Timing. We measured entry timing as the timing
of a firm’s investment in a product sector in China, as
compared with other foreign competitors. First, we
coded the dummy variable “early entrants” as 1 if a
foreign firm was among the first firms to enter a four-
digit CIC product sector in the same calendar year and
0 if otherwise. We identified 759 (2.9%) foreign firms
as early entrants in our sample. Second, we measured
the continuous measure “lag time” by late entrants’
delay in the years after the early entrants entered a spe-
cific product sector.

Entry Mode. The database categorizes foreign-invested
firms into three groups: contractual joint ventures,
equity joint ventures, and wholly owned subsidiaries.
We used contractual joint ventures as the baseline in our
analysis. Our sample comprised 2826 contractual joint
ventures, 14,929 equity joint ventures, and 7748 wholly
owned subsidiaries.

Investment Size. We measured investment size as the
initial investment a foreign firm made when it estab-
lished its subsidiaries in China. We used the logarithm
transformation.

Control Variables

We controlled for the following variables that might have
an impact on the performance of foreign-invested firms.
We measured industry concentration with the Herfindahl
index and industry growth with investment growth rate
(based on a two-digit CIC code) as a proxy. We obtained
these data from the China Statistical Yearbook. These
two measures were five-year averages for the 1998–2002
period. We coded firm location as 1 if a firm was located
in national municipalities or Eastern provinces and 0 if
otherwise. Table 1 reports the basic statistics and the cor-
relation matrix of the variables in the study.

Models

We employed multiple linear regression to examine mar-
ket share performance. We investigated possible multi-
collinearity in the models before conducting regression
analyses. We found that the variance inflation factor val-
ues were well below the cutoff threshold of 10, which indi-
cates that there is no serious problem of multicollinearity
in our models (Hair et al. 1998; Neter, Wasserman, and
Kutner 1996). Model 1 tests the main effects of the inde-
pendent variables on market shares as the measure of per-
formance. Model 2 confirms the results of Model 1 by
using “lag time” as another indicator of entry timing.
Model 3 tests both the main and the interaction effects on
market shares. Table 2 reports the results.

Table 1. Descriptive Statistics and Correlations

1 2 3 4 5 6 7 8 9

1. Early entrants 1.00

2. Lag time –.42* 1.00

3. Equity joint ventures .07* –.13* 1.00

4. Wholly owned subsidiaries –.07* .14* –.78* 1.00

5. Investment size .04* –.11* .05* –.04* 1.00

6. Industry concentration .19* –.31* .05* –.03* .06* 1.00

7. Industry growth –.05* .17* –.12* .12* –.20* –.09* 1.00

8. Firm location –.03* .03* –.19* .16* –.06* –.04* .14* 1.00

9. Market share .18* –.20* .01 .02* .24* .38* –.01 .02* 1.00

M .03 10.08 .59 .30 9.23 .02 .27 .84 .01

SD .17 4.23 .49 .46 1.56 .04 .18 .37 .02

*p < .01 (two-tailed test).

58 Journal of International Marketing

For foreign firms’ survival, we employed an accelerated
event-time model in our study (Allison 1995). The accel-
erated event-time model incorporates censored cases
into the estimation of the survival function. It assumes
that the values of the dependent variable are distributed
according to an underlying parametric distribution and
that the distribution accelerates or decelerates through
the influence of a set of covariates. The Weibull distribu-
tion was specified. We also tested other parametric dis-
tributions, including exponential distribution, and
obtained consistent results. Model 4 tests the main
effects of the independent variables on firm survival.
Model 5 confirms the results of Model 4 by using “lag
time” as another indicator of entry timing. Finally,
Model 6 tests both the main and the interaction effects
on firm survival. Table 3 reports the results.

RESULTS

Table 2 contains the estimates of the factors that influ-
ence foreign firms’ average market shares. We report a
set of models of the accelerated event-time estimation in
Table 3. The coefficient estimates represent the effects of
the covariates on the survival of foreign firms. There-
fore, significantly positive coefficients indicate that the
survival of firms increases as the value of a covariate
increases.

In H1a and H1b, we propose that early entrants to a for-
eign market have higher market shares and lower sur-
vival rates than late entrants. The findings show that the
variable early entrants is negatively related to firm sur-
vival (p < .01) but positively related to market shares

Table 2. Multiple Regression Estimates of Entry Timing, Entry Mode, and Investment Size on Market Shares

Dependent Variable: Market Shares

Model 1 Model 2 Model 3

Independent Variables

Intercept –2.933* (.083) –2.483* (.089) –2.898* (.082)

Early entrants 1.243* (.066) — 1.422* (.076)

Lag time — –.037* (.003) —

Equity joint ventures (EJVs) .051 (.036) .053 (.036) .050 (.036)

Wholly owned subsidiaries (WOSs) .181* (.038) .196* (.038) .148* (.038)

Investment size .282* (.007) .278* (.007) .281* (.007)

Interaction Effects

Early entrants × investment size — — .880* (.039)

Early entrants × EJVs — — –.226 (.213)

Early entrants × WOSs — — 2.391* (.271)

Control Variables

Industry concentration .180* (.003) .176* (.003) .177* (.003)

Industry growth .007* (.001) .007* (.001) .007* (.001)

Firm location .178* (.030) .167* (.031) .175* (.030)

Model Indexes

Number of observations 25,089 25,082 25,089

F-value 939.33* 900.29* 739.08*

Adjusted R2 .21 .20 .23

R2 change — — .02*

*p < .001. Notes: Numbers in parentheses are standard errors.

Foreign Market Entry Timing Revisited 59

(p < .01). In addition, lag time has a positive effect on firm survival (p < .01) but a negative effect on market shares (p < .01). The results suggest that early entrants achieve higher market shares than late entrants in a for- eign market, but they also bear greater exiting risks. Therefore, H1a and H1b are supported. To further explore the trade-off between market share performance and survival of early entrants, we report the average market shares of foreign firms in Table 4. For early entrants, exiting and surviving firms have an average market share of 2.3% and 2.7%, respectively. For late entrants, exiting and surviving firms have an average market share of .3% and .6%, respectively. Although the market share performance of some early entrants is

significantly better than some late entrants (2.3% >
.6%; p < .001), their performance is still insufficient to support and sustain their operations in facing early entry uncertainties and risks.

In H2a and H2b, we propose that wholly owned sub-
sidiaries have higher market shares and survival rates than
equity joint ventures, followed by contractual joint ven-
tures having the lowest market shares and survival rates.
The results show that wholly owned subsidiaries have
higher market shares and survival rates than contractual
joint ventures (p < .01). However, we find that equity joint ventures are not significantly different from contrac- tual joint ventures in their market share performance and

Table 3. Accelerated Event-Time Estimates of Entry Timing, Entry Mode, and Investment Size on Firm Survival

Dependent Variable: Market Shares
Model 1 Model 2 Model 3
Independent Variables

Intercept .245** (.047) .134** (.051) .248** (.047)

Early entrants –.155** (.036) — –.150** (.043)

Lag time — .009** (.002) —

Equity joint ventures (EJVs) .010 (.020) .010 (.020) .009 (.020)

Wholly owned subsidiaries (WOSs) .184** (.022) .178** (.022) .177** (.023)

Investment size .151** (.004) .153** (.004) .151** (.004)

Interaction Effects

Early entrants × investment size — — .014 (.024)

Early entrants × EJVs — — .205* (.105)

Early entrants × WOSs — — .225 (.148)

Control Variables

Industry concentration .018 (.172) .199 (.181) .008 (.173)

Industry growth –.037 (.035) –.054 (.036) –.039 (.035)

Firm location .143** (.017) .145** (.017) .143** (.017)

Scale parameter .645 (.006) .645 (.006) .645 (.006)

Weibull shape parameter 1.550 (.014) 1.550 (.014) 1.550 (.014)

Model Indexes

Number of observations 25,094 25,087 25,094

Number of exits 10,382 10,377 10,382

Log-likelihood –23,424.78 –23,408.62 –23,422.75

*p < .05. **p < .001. Notes: Numbers in parentheses are standard errors.

60 Journal of International Marketing

survival rates. Therefore, H2a and H2b are only partially
supported. The data do not support the performance
difference between equity and contractual joint ven-
tures. A plausible explanation is that both equity and
contractual joint ventures represent a partnership
between a foreign and a Chinese local firm, but in dif-
ferent forms (Pan, Li, and Tse 1999). Both types of joint
ventures entail high cooperation costs with a low level
of managerial control (Cui and Lui 2005). Therefore,
the difference between equity and contractual joint ven-
tures is less profound.

In H3a and H3b, we predict that foreign firms with large
initial investments have higher market shares and sur-
vival rates. The results in Tables 2 and 3 show that
investment size has a positive impact on firms’ market
shares (p < .01) and survival rates (p < .01). The results suggest that foreign firms with a large investment size achieve higher market shares and survive longer in a for- eign market. Therefore, H3a and H3b are supported.

In H4a and H4b, we propose that entry mode has a posi-
tive moderating effect on both the entry timing–market
share relationship and the entry timing–survival rela-
tionship, with early entrants as wholly owned sub-
sidiaries having the highest market shares, followed by
equity joint ventures and then contractual joint ven-
tures. For market share performance, the interaction
term of entry timing with equity joint ventures is non-
significant, and the interaction term of entry timing with
wholly owned subsidiaries is positively related to a
firm’s market share (p < .01). Therefore, H4a is partially supported. For firm survival, the interaction term of entry timing with equity joint ventures is positively related to a firm’s survival, though the effect is only mar- ginally significant (p < .10). The effect of the interaction term of entry timing with wholly owned subsidiaries is also positive, though nonsignificant (p < .13). Therefore, H4b is only weakly partially supported.

H5a and H5b pertain to the interactive effects of entry
timing and investment size. We anticipate that invest-
ment size has a positive moderating effect on both the
entry timing–market share and the entry timing–survival
relationships. We find that the interaction term of entry
timing with investment size has a significant and posi-
tive impact on a firm’s market share performance (p < .01). However, the interaction term has a nonsignificant effect on a firm’s survival. Therefore, H5a, but not H5b, is supported.

DISCUSSION
Contributions

Firms face several critical decisions when considering
market expansion, including entry timing, entry mode,
and investment size (Delios and Makino 2003; Papyrina
2007; Stalk and Hout 1990; Vesey 1991). In this study,
we examine the effects of these important variables on
market share performance and survival rate of foreign-
invested firms. Using a longitudinal database of manu-
facturing firms in China, we investigate 25,513 foreign
firms in 610 product sectors. The detailed four-digit CIC
offers specific industry classifications, enhancing prod-
uct sector comparability and better reflecting economic
phenomena in the fast-growing emerging economy of
China.

Specifically, our study provides three contributions to the
literature. First, our study contributes to extant research
on entry timing strategies by directly examining the
trade-off between market share performance and firm
survival for early entrants. Entry timing may yield differ-
ential effects on various measures of firm performance;
therefore, it is critical to employ multiple performance
measures (Mitchell 1991). Our findings reveal that simi-
lar patterns exist in the context of international markets.
We examine the impact of entry timing on both market
share performance and survival of foreign firms. The
results suggest that though early entrants achieve higher
market shares than late entrants, they also suffer from
lower survival rates. This finding is consistent with first-
mover advantages literature and echoes previous studies
of early-entrant advantages in international markets. We
also find that early entrants are more likely to withdraw
from the foreign market than late entrants. This is
because early-entrant advantages may diminish as the
market evolves (Delios and Makino 2003; Wang, Chen,
and Xie 2010). Therefore, early entrants to a foreign
market face a trade-off between their survival chances
and market share performance. In summary, early

Table 4. Market Share Performance of Early and Late
Entrants

Entry Timing Firm Survival Average Market Share

Early entrants Exiting firms 2.3%

Surviving firms 2.7%

Late entrants Exiting firms .3%

Surviving firms .6%

Foreign Market Entry Timing Revisited 61

entrants gain first-mover advantages but also face sur-
vival disadvantages in a foreign market. The results in
Table 4 show that though the market shares of existing
early entrants are significantly higher than those of late
entrants, their performance is still not sufficient to main-
tain their operations. Accordingly, it is critical for early
entrants to capture a high enough market share to sur-
vive in foreign markets because surviving entrants also
achieve high market performance (through their willing-
ness to take risks).

Second, and more importantly, regarding the trade-off
between high market shares and low survival rate of
early entrants, we offer potential strategies that firms
can adopt to better balance different performance indi-
cators. The key to the first-mover advantage–
early-entrant survival disadvantage dilemma lies in cer-
tain strategic choices that can help early market
entrants maintain higher market shares. In this study,
we focus on entry mode and investment size as two
such strategic choices that firms can use to deal with the
trade-off between market share performance and sur-
vival. The results show that the interaction terms of
entry timing with equity joint ventures and entry timing
with wholly owned subsidiaries are positively related to
a firm’s survival. For market share performance, the
interaction term of entry timing with wholly owned
subsidiaries is positively related to a firm’s market
share. In other words, early entrants with a wholly
owned subsidiary entry mode have higher market
shares and survival rates than early entrants with equity
and contractual joint ventures. Thus, it is critical for
foreign firms to evaluate the distinctive advantages
gained from different modes of entry. Early entrants
can enjoy superior performance by choosing an appro-
priate entry mode that helps reduce the substantial risks
encountered. Investment size is another strategic choice
that firms can select to enhance performance in inter-
national contexts. We find that the interaction term of
entry timing with investment size has a significant
impact on a firm’s market share performance. There-
fore, early entrants with large initial investments are
more capable of exploiting and realizing first-mover
advantages to improve their market share performance.
In other words, if early entrants are willing to commit
substantial resources to their target markets, they will
be rewarded with higher market share.

Third, the strategic choice perspective suggests that
managerial choices affect organizational design out-
comes and firm performance (Priem and Harrison
1994). Scholars have voiced concerns that strategic

choices examined in empirical studies are often defined
by the outcomes achieved (Drazin and Sandelands
1992), such that these choices “are generally inferred
from tangible organizational outcomes rather than
directly measured” (Preim and Harrison 1994, p. 321).
We contribute theoretically to the entry timing and
strategic choice literature by examining and measuring
two strategic choices (i.e., entry mode and investment
size) and further evaluating how these choices affect the
entry timing–performance outcome.

Managerial Implications

Our study provides important managerial implications
for foreign market entry. First, we draw marketing man-
agers’ attention to the performance paradox (Ostroff
and Schmitt 1993) that achieving a desirable outcome in
one performance aspect may have a negative effect on
another aspect. Our study is the first to provide guidance
on how managers can achieve the duality of high market
share performance and survival. Early foreign market
entry is a double-edged sword for marketing practition-
ers: Although it provides early entrants with a high mar-
ket share, it also imposes high survival risks and uncer-
tainties. To be successful in foreign markets, managers
need to gain a deeper understanding of the overall impact
of foreign entry timing as well as other important strate-
gic choices. Our findings advocate a risk-taking approach
for early entrants. Indeed, early market entrants face dis-
advantages of higher uncertainties than late entrants
(Delios and Makino 2003; Frynas, Mellahi, and Pigman
2006; Wang, Chen, and Xie 2010). Although firms can
select a wait-and-see option, it is important for them to
understand that though, on average, early entrants have a
higher failure rate than late entrants, opportunities do
exist for them to enjoy early entry benefits, and they can
amplify such advantages by speeding up their sequential
entry pace (Gao and Pan 2010). Instead of hedging their
risks, our findings suggest that firms should take full con-
trol of their operations (by adopting the mode of wholly
owned subsidiaries) and commit more resources (by mak-
ing a large initial investment) so that they can overcome
the risks and uncertainties.

Second, we argue that in developing marketing strategies,
managers should treat environmental conditions as the
ultimate determinants of organizational characteristics
and exercise their strategic choice in achieving desirable
outcomes (Child 1997). Managers should be cognizant
that their strategic choice “extends to the environment
within which the organization is operating, to the stan-
dards of performance against which the pressure of

62 Journal of International Marketing

economic constraints has to be evaluated, and to the
design of the organization’s structure itself” (Child 1972,
p. 2). Thus, market entry strategies need to be aligned not
only with resource commitment but also with appropri-
ate governance forms to achieve multiple performance
outcomes. After all, only surviving early entrants can
enjoy sustainable market share performance. Therefore,
our study highlights the important trade-off between
market share and survival for foreign early market
entrants and the significant moderating effects of strategic
choices on the first-mover advantage–early-entrant sur-
vival disadvantage dilemma and on the entry timing–
performance relationship.

Limitations

Our study has several limitations that also provide impe-
tus for further research on foreign entry timing. First, the
study is based on archival data, and as a result, we could
not examine the motivation of FDI. Foreign firms may
enter a host market for different purposes, ranging from
resource seeking to local market seeking. The motivation
of foreign firms should have a significant impact on
whether and how they can capitalize on early-entrant
advantages. The data limitation also prevented us from
capturing other important variables, such as firm innova-
tiveness. Second, our study focuses on FDI in a single host
country (i.e., China). Further research could extend the
study scope by examining whether the findings can be
generalized to other host countries. Finally, with respect
to firm survival, we could not differentiate exit types.
Exits, such as firm closure and capital divestiture, are not
always an indicator of failure of foreign subsidiaries.
Additional studies could incorporate different types of
exits and examine whether early and late entrants exhibit
different exit patterns.

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Exchange rate risk exposure and the value of
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Fabio Parlapiano, Vitali Alexeev & Mardi Dungey

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Exchange rate risk exposure and the value of European firms

Fabio Parlapianoa,b∗, Vitali Alexeevb and Mardi Dungeyb,c
aManagement Department, Sapienza University of Rome, Rome, Italy; bTasmanian School of Business and Economics,
University of Tasmania, Hobart, Australia; cCenter for Financial Analysis & Policy, University of Cambridge Judge
Business School, Cambridge, England

(Received 25 March 2013; final version received 23 December 2014)

This paper presents a new assessment of the exposure of European firms to exchange rate fluctuations
which takes into account the potential common drivers of exchange rates and equity market conditions.
Using monthly data for European firms from 1999 to 2011, we assess the impact of unexpected fluctua-
tions in the USD, JPY, GBP and CHF against the Euro, and show that the proportion of firms subject to
exchange rate risk is considerably larger when estimation accounts for potential common drivers and firm-
specific factors than otherwise. Firm exposure to exchange rate risk is affected by the level of international
involvement, industry, firm size and country of origin. European firms with largely domestic operations
reveal the greatest vulnerability to unexpected exchange rate movements, suggesting an opportunity to
improve risk management for these companies.

Keywords: exchange rate risk; firm value; European firms

AMS Subject Classifications: G32; F31; F23; G15

1. Introduction

Currency volatility is a leading concern for companies around the world; risk managers consider
currency fluctuations as amongst the top three risk factors, dominating overall economic and mar-
ket risk (Economist Intelligence Unit 2011). Currency fluctuations may affect firm value via cash
flows, and although firms often use hedging strategies, currency exposure is not completely elim-
inated. The existing literature reports weak, and mixed, evidence on the significance of exchange
rate risk; see, for example, for the USA, Jorion (1990), Amihud and Levich (1994) and Bodnar
and Wong (2003) and, for international evidence, Bodnar and Gentry (1993) and Dominguez and
Tesar (2001). The majority of the existing evidence considers US data for non-financial firms
and employs an estimation strategy of regressing individual firm or portfolio returns on the con-
temporaneous exchange rate change and an indicator of market portfolio return – an augmented
capital asset pricing model (CAPM) style model promoted in Jorion (1990) and subsequent work.
However, Doukas, Hall, and Lang (2003) convincingly argues that at least part of the lack of
evidence for the impact of exchange rate changes on individual firms arises from the commonly
implemented modelling assumption that aggregate stock markets are independent from exchange

∗Corresponding author. Email: fabio.parlapiano@uniroma1.it. Current address: Risk Management Department, Bank of
Italy, Rome, Italy.

mailto:fabio.parlapiano@uniroma1.it

112 F. Parlapiano et al.

rates; see also Priestley and Ødegaard (2007). There is significant evidence that aggregate stock
markets and exchange rates are related, albeit exchange rates may exert lower influence on stock
markets than other factors; see, for example, Roll (1992) and Granger, Huang, and Yang (2000); a
theoretical model in Hau and Rey (2006) and recent evidence on bi-directional Granger causality
between exchange rate and stock market returns in Inci and Lee (2014).

This paper considers the impact of exchange rate fluctuations on European firms for the
period 1999–2011 using the Doukas, Hall, and Lang (2003) orthoganalized model approach.
European firms have not previously been examined in a framework accounting for the com-
mon forces driving exchange rates and equity market changes. We extend the existing literature
on European firms, summarized in Table 1, with the use of firm-level data from all sectors
of the economy, including financial and non-financial firms, and firms which are active in
international markets and those concerned only with domestic markets. Firms which solely con-
centrate on domestic markets are often omitted from analysis, but recently Amiti, Itskhoki, and
Konings (2014) provide both a theoretical framework and empirical evidence (from Belgium)
that these firms are likely to be considerably more exposed to exchange rate fluctuations than
their more internationally active counterparts. Our findings confirm this evidence for Europe as
a whole. We find evidence that a larger fraction of firms are affected by exchange rate fluctu-
ations in the value of the Euro against other currencies than identified under the independence
assumptions used in the Jorion (1990) framework. For example, in the case of fluctuations of
the value of the JPY against the Euro the fraction of firms almost doubles to 27.60% using
the orthoganalized model compared with the 15.88% identified with the Jorion (1990) method.
Similar results apply for fluctuations in the value of the USD, GBP and CHF against the
Euro.

The impact of exchange rate fluctuations may also vary with firm characteristics, and we make
a thorough exploration of the role of industry sector, firm size and level of international activity
as potential determinants. In addition, we consider the relevance of the country of origin of the
firm, reflecting the potential importance of sovereignty within a currency union. Although it is
well documented that the European common currency area resulted in reduced exchange rate risk
for firms in member countries, particularly for those with foreign business activity (Bartram and
Karolyi 2006; Koutmos and Knif 2011), significant risk remains (Adjaouté and Danthine 2004;
Muller and Verschoor 2006a,b; Hutson and O’Driscoll 2010) even after accounting for improved
risk management practices via hedging (Nguyen, Faff, and Marshall 2007). We find that the
industry sector and country of origin of a firm are important determinants of the exchange rate
exposure for an individual firm. The financial sector is more exposed to unexpected exchange
rate fluctuations, and countries that became deeply embroiled in the European sovereign debt
crises from 2010 onwards had greater exposure, particularly affecting firms in Portugal, Ire-
land, Greece and Spain. We also find that the relationship between the degree of response to
unexpected market shocks and unexpected exchange rate shocks is not monotonic. Defensive
securities tend also to be those with the lowest response to exchange rate risks. Firms below the
50th percentile of estimated beta display a positive relationship between increasing market risk
and increasing exchange rate risk. However, after the 50th percentile (β = 0.8), the sensitivity
of firms to exchange rate risk tends to decline with increasing market risk. That is, aggressive
securities are not necessarily as exposed to exchange rate fluctuations than their more defensive
counterparts.

The paper proceeds as follows. Section 2 outlines the methodology for empirically detecting
exchange rate risk for individual firms. Section 3 describes the newly collected data set. The
results are presented and discussed in Section 4, and Section 5 concludes.

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Table 1. Summary of empirical literature on exchange rate exposure for the Eurozone.

Authors
Exchange
rate indexa

Exchange rate
exposure

Financial
marketsb

Sampled
firms Data period Frequency Market index

% Significantly
exposedc

Muller and Ver-
schoor (2006a)

Cross USD,
GBP,

JPY

Contemp. Eurozone (20) 817 non-
financial
MNCs

1988–2002 1;4;12;54
weeks

VW EMU 13%JPY; 22%
GBP; 14% USD;

Bartram and
Karolyi (2006)

TW ER index Contemp. Eurozone (18),
US, JP

3220 non-
financial

1990–2001 Weekly Market indices
for each
country

7.3% negative,
4.7% positive

Nguyen, Faff,
and Mar-
shall (2007)

French TW ER
index

Contemp. France 99 non-
financial
MNCs

1996–2000 Monthly France CAC 40 30.30%

Hutson and
O’Driscoll
(2010)

TW ER index Contemp. Eurozone (7)
and non-
Eurozone
(4)

1154 1990–2008 Monthly DataStream
weighted for
each country

8.4% pre-Euro;
9.1% post-Euro

Koutmos and
Knif (2011)

Cross USD Contemp. Finland 6 industry
and 4 size
portfolios

1992–2006 Weekly NASAQ OMX
Helsinki
market index

4 industry and 4
size portfolios
pre-Euro;
2 industry
portfolios
post-Euro

Inci and
Lee (2014)

TW ER index Lagged France,
Germany,
Italy

MNCs 1984–2009 Yearly MSCI country
indices

5 out of 8 country
portfolios

This study Cross USD,
GBP, JPY,

CHF

Contemp. Eurozone (15) 650 financial
and non-
financial,
MNCs and
domestic

1999–2011 Monthly Euro Stoxx TMI
and Euro
Stoxx 50

StoxxTMI 27.60%
JPY; 13.04%
USD; 10.78%
GBP. Stoxx 50
42.86% JPY;
26.53% USD;
20.41%

GBP

aAbbreviations used: trade weighted (TW); value weighted (VW); exchange rate (ER); cross denotes cross-rates of (the Euro) with other currencies.
bFigure in parentheses denote the number of countries in the study.
cWe report the main result from each study. Figures represent the percentage of firms significantly exposed to fluctuations of exchange rates considered.

114 F. Parlapiano et al.

2. Modelling framework

A model commonly used in the literature considers the direct regression of contemporaneous
exchange rate changes on individual firm stock returns, controlling for market conditions via a
common market indicator. That is, an augmented CAPM model is as follows:

rit = β0i + β1irst + β2irmt + μit, (1)
where the stock return, rit, for a firm i is regressed on the contemporaneous exchange rate return,
rst, and the market portfolio return, rmt. The loading β1i represents the exposure of the individual
firm to exchange rate movements having conditioned on the broad equity market. When β1i is
positive (negative), a rise in the exchange rate increases (decreases) the value of the stock for the
individual firm in excess of market fluctuation.

A problem with the specification given in Equation (1) is that it is predicated on the exchange
rate movements and market conditions being uncorrelated. As there is significant evidence that
aggregate equity market returns are related to exchange rate movements via common factors
(see, for example, Phylaktis and Ravazzolo (2005)) this means that Equation (1) is subject to
collinearity, with consequent unknown bias in the estimated coefficients.

An alternative is to apply the three step procedure of Doukas, Hall, and Lang (2003) which
orthogonalizes the market and exchange rate risk factors; see also He, Ng, and Wu (1996). The
first step removes from the exchange rate returns the effect of common macroeconomic funda-
mental influences which might be expected to influence both equity markets and exchange rates.
There is abundant evidence linking indicators such as aggregate activity, inflation, employment,
interest rates and other indicators to both equity market returns and exchange rates; for example,
Chordia and Shivakumar (2002) and Flannery and Protopapadakis (2002) on macro fundamen-
tals in forecasting and announcement effects on stock returns; Beckmann, Belke, and Kuhl (2011)
for recent evidence on macro variables and the Euro and Taylor (1995) on exchange rate mod-
els. Regressing these control variables on the exchange rate returns, we obtain the unexpected
exchange rate returns from

rst = β0 +
6∑

j=1
βjCVj,t−1 + β7rst−1 + εst, (2)

where CVj,t−1 are lagged control variables and rst−1 controls for any autocorrelation in exchange
rate returns. The unexpected exchange rate returns are the fitted residuals from Equation (2),
that is ε̂st. The second stage orthogonalizes equity market returns to the same set of common
control variables and the unexpected exchange rate returns from step (2), while also controlling
for autocorrelation in the market returns as follows:

rMmt = β0 +
6∑

j=1
βjCVj,t−1 + β7rMmt−1 + β8ε̂st + eMmt, (3)

where rMmt is the stock market return. The orthogonalized indicator of the market returns will be

given by the estimated residuals, êMmt.
There remains the possibility that exchange rates and market returns retain a common factor

through some alternate effect which has not been captured in the model, something which can
be addressed with latent factor models or principal components but with the accompanying dis-
advantage of being unable to observe the contributing feature. For example, Doukas, Hall, and

The European Journal of Finance 115

Lang (2003) include Fama–French factors in their analysis (Fama and French 1992, 1993). While
these factors have been successfully associated with returns premia around the world, they dif-
fer across markets. Dimson, Marsh, and Staunton (2002) document country-specific differences
among the European countries both for size and growth premia, hence a unique measure of these
factors cannot be applied at the Eurozone level.

Finally, the third stage regression estimates the sensitivity of individual firm stock returns to
the unexpected exchange rate and unexpected market returns as follows:

rit = αi,0 +
6∑

j=1
βijCVij,t−1 + βi7rit−1+βimêMmt + βisε̂st + γit, (4)

where we now consider the effect of the economic factors and the unexpected components of the
exchange rate and market returns. The coefficient βis represents the sensitivity of the returns for
an individual firm, rit, to unexpected exchange rate movements.

3. Data

Focusing on firms with operations in the Eurozone, we consider all constituents of a broad market
index, the Euro Stoxx TMI (600 firms), and constituents of a large capitalization index, the
Euro Stoxx 50 (50 firms) for the period 1999–2011. Both indices have diverse coverage of the
Eurozone countries and sectors, with an economic performance benchmark of the Eurozone in
the former, and a large capitalization focus and value weighted selection criteria in the latter.1

The large number of firms in the sample allows for a breakdown based on geographical location,
industry and level of international involvement. Monthly data used in this study are obtained
from Bloomberg and Stoxx Ltd.

Two main sources of biases related to the inclusion of large stocks in the market index have
been discussed in the literature. The size (or positive) bias affects the estimation of exchange
rate exposure due to higher proportion of exports of large firms (Bodnar and Wong 2003). The
success bias, instead, inflates the market risk premium estimation when stocks included in value
weighted indices experienced a sustained growth path (Dimson, Marsh, and Staunton 2002). We
are able to account for the mentioned size and success biases by the use of a broad market index
such as the Euro Stoxx TMI.

In order to account for the firm’s level of involvement in international operations or, more
precisely, non-Eurozone operations, we construct the ratio of each firm’s non-Eurozone revenues
to total revenues, hereafter the Foreign Exchange Exposure (FEE) index. The average degree of
international involvement in period from 2005 to 2010 is higher for Euro Stoxx 50 constituents
(at 46%) than for Euro Stoxx TMI (at 39.5%). On average, large European firms make approxi-
mately half of their revenues outside the Eurozone countries. The FEE index for Euro Stoxx 50
constituents is more homogeneous than for Euro Stoxx TMI constituents, which is not surprising
given the wide industry coverage that characterizes the TMI.

We group the firms by their degree of international involvement on the basis of the FEE index
threshold as in Doukas, Hall, and Lang (2003). We consider high exporters (or MNCs), low
exporters, and non-exporters (or domestic firms). The highest concentration of MNCs (high
exporters) is in the industrial sector (73%) followed by utilities (50%) and real estate (37.5%).
On the other side of the spectrum, the proportion of domestic firms is highly concentrated in
non-industrials, that is financials, banking, and insurance sectors.

116 F. Parlapiano et al.

Monthly data for the set of economic variables and nominal bilateral exchange rates are
obtained from the ECB Statistical Data Warehouse. We adopt the indirect exchange rate quotation
from the point of view of the Eurozone, therefore, positive exchange rate returns imply apprecia-
tion of the EURO. To be completely clear, this implies that we express all exchange rates in terms
of the foreign currency cost of one Euro; thus when the value of the Euro falls, the exchange rate
falls. Following Chen, Roll, and Ross (1986) and Doukas, Hall, and Lang (2003), we rely on
six control variables to express macroeconomic conditions: unexpected inflation (UI), industrial
production (IP), term premium (TP), money supply (MS), interest rate spread (IRS), and trade
balance (XM ). With the exception of the UI, all of the control variables are selected and computed
following Chen, Roll, and Ross (1986) and Doukas, Hall, and Lang (2003) specifications.2

4. Results

Table 2 reports the results of the first stage regressions for all four currencies. The currency pairs
are only weakly influenced by the set of macroeconomic fundamentals. Only the first lag of the
exchange rate return (in the case of JPY and USD), the Euro area money supply (in the case of
USD), unexpected inflation (in the case of CHF) and interest rate spread (in the case of CHF) are
significant determinants of exchange rate changes. While the joint hypothesis of zero coefficients
for all explanatory variables is rejected for the Euro exchange rates against the JPY, USD and
CHF, the Euro exchange rate with the GBP is found to be independent of all the macroeconomic
variables considered. The poor performance of macroeconomic fundamentals in forecasting short
run exchange rates is consistent with existing literature. Meese and Rogoff (1983) first pointed
to the random walk behavior of exchange rates, but subsequent work of Engel and West (2005)
and Andersen, Tim Bollerslev, and Vega (2003) point to the existence of some, although weak,
links between economic fundamental news and exchange rates.

The estimate of the unexpected exchange rate return from stage 1 is incorporated into the
second stage regression for the equity market returns proxies, Euro Stoxx TMI or Euro Stoxx
50, also reported in Table 2. The Eurozone stock market is only weakly influenced by the set
of macroeconomic fundamentals, but in each case the models reject the joint hypothesis of no
influence of all macroeconomic variables. There is some evidence that realized inflation is nega-
tively correlated with stock market returns, consistent with the inflation puzzle of Fama (1981);
see also Geske and Roll (1983) and Flannery and Protopapadakis (2002) for later evidence.

The influence of the unexpected exchange rate movements in the Euro against the JPY and
CHF, generated from the first stage regressions, on the stock market returns is found to be signif-
icant and positive for both stock market proxies. This result is consistent with those of Doukas,
Hall, and Lang (2003) for Japanese firms, but differs from the earlier studies of Chen, Roll, and
Ross (1986) and Hamao (1988) for US and Japanese markets, respectively. In the cases of the
other currencies, GBP and USD, there is no significant effect from the generated unexpected
exchange rate changes.

The effect of unexpected exchange rate changes on individual stock returns is the primary
interest of this paper. The third stage regression considers this via the impact of the generated
orthogonal unexpected exchange rate change and the market return residuals on the individual
stock returns, as per Equation (4).

Table 3 summarizes the heteroskedasticity robust ordinary least-squares (OLS) estimates of
the exchange rate exposure for Euro Stoxx TMI and Euro Stoxx 50 constituent stocks, respec-
tively. We report the percentage of firms significantly affected by unexpected exchange rate

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Table 2. Results of the first and second stage regressions in the orthogonalized market model.

Second stageb

First stagea

Euro Stoxx TMI Euro Stoxx 50

Variables JPY USD GBP CHF JPY USD GBP CHF

JPY USD GBP CHF

Intercept 0.02 0.02 0.00 0.00 0.07** 0.02 0.02 0.05 0.06* 0.01 0.01 0.04
Unexpected

inflation
UIt−1 − 3.72 − 4.38 2.88 − 5.28** − 21.60** − 14.72 − 24.32*** − 22.95*** − 22.64** − 13.60 − 25.07*** − 24.32***

Industrial
production

IPt−1 0.14 0.15 − 0.11 0.05 0.13 − 0.09 − 0.01 0.12 0.24 − 0.01 0.09 0.28

Term premium TPt−1 − 0.81 − 0.24 − 0.22 − 0.26 − 0.76 0.66 0.65 0.05 − 0.46 0.70 0.68 0.11
Money supply MSt−1 − 0.28 − 0.57** 0.10 0.14 − 0.17 − 0.32 − 0.46 − 0.19 − 0.17 − 0.36 − 0.52 − 0.22
Interest rate

spread
IRSt−1 0.28 − 0.18 − 0.18 − 0.58** 0.78 0.81** 1.46*** 0.39 0.47 0.95** 1.67*** − 0.01

Trade balance XM t−1 0.09 0.05 − 0.02 0.02 0.00 0.06 − 0.12 − 0.02 − 0.03 0.06 − 0.15 − 0.06
Lagged exchange

rate return
rst−1 0.25*** 0.25*** 0.11 − 0.07

Lagged market
return

rMmt−1 0.06 0.03 0.03 0.02 0.04 − 0.01 − 0.01 − 0.03

Unexpected
exchange rate

εst 0.43*** 0.21 0.27 1.18*** 0.44** 0.23 0.28 1.21***

F-statistic 2.73** 3.25*** 1.67 2.22** 2.88*** 2.49** 3.16*** 3.33*** 2.49** 2.45** 3.23*** 3.05***
R2 adjusted 0.07 0.09 0.03 0.10 0.09 0.07 0.10 0.16 0.07 0.07 0.11 0.15
JB-statistic 12.55*** 59.31*** 24.46*** 184.32*** 27.39*** 33.62*** 35.47*** 34.38*** 27.37*** 31.79*** 29.39*** 34.19***

Notes

: Estimated using monthly data from 1999 to 2011. The JB-statistic reports the result of the Jacque–Bera normality test on the residuals.
aFirst stage results are from Equation (2).
bSecond stage results are from Equation (3).
*Significance at 10%.
**Significance at 5%.
***Significance at 1%.

118 F. Parlapiano et al.

Table 3. Exchange rate exposure of European firms (orthogonalized market model).

Euro Stoxx TMI Euro Stoxx 50
JPY

Currency trend − 12.05%
Average β

(a)
s 0.82 0.67

Total significance 146 (27.60%) 21 (42.86%)

(N +)β(b)s 142 20
(N −)β(c)s 4 1

USD

Currency trend 30.80%
Average βs 0.68 0.59
Total significance 69 (13.04%) 13 (26.53%)
(N +)βs 62 12
(N −)βs 7 1

GBP

Currency trend 30.85%
Average βs 0.70 0.95
Total significance 57 (10.78%) 10 (20.41%)
(N +)βs 48 10
(N −)βs 9 0

CHF

Currency trend − 24.38%
Average βs 1.88 1.64
Total significance 279 (52.74%) 33 (67.35%)
(N +)βs 279 33
(N −)βs

Notes: Equation (4) estimated using monthly data from 1999 to 2011. Heteroskedasticity robust OLS
estimates of the exchange rate exposure, βis , are reported along with the percentage of firms significantly
affected by exchange rate fluctuations, the average magnitude of significant exposure coefficients and
the number of firms positively, N +, and negatively, N −, affected by currency variations.
(a)Average of significant βis from Equation (4) on page 8.
(b)Number of significant and positive βis from Equation (4).
(c)Number of significant and negative βis from Equation (4).

fluctuations, the average magnitude of the coefficients, βis and the number of firms positively
and negatively affected by currency variations.

The first panel of Table 3 reports the results for unexpected changes in the exchange rate of
the JPY against the Euro. Just over 27% of the Euro Stoxx TMI constituents have a significant
response to unexpected changes in the value of the Yen against the Euro, with an on-average
appreciation of 8.2% in the stock returns for each 10% appreciation of the Euro. The impact of
an appreciation in the Euro against the USD and GBP is also positive at an average of around
7% (the second and third panels of Table 3), but the proportion of firms with significant impact
is fewer than half that in the Japanese case.

An astonishing 52% of firms are significantly affected by CHF fluctuations with as many as
72% of affected firms among the financial firms with an overall average appreciation of 18.8% in
the stock returns for each 10% appreciation of the Euro against the CHF. This large proportion of

The European Journal of Finance 119

European firms exposed to the Swiss Franc may reflect a speculative demand of the CHF, in the
form of foreign debt (see Keloharju and Niskanen 2001), which might be driven by the interest
rate differentials between the Eurozone and Switzerland making it convenient to borrow funds
denominated in Swiss Francs (see Brunnermeier, Nagel, and Pedersen 2008; Galati, Healt, and
Guire 2007 on the role of the CHF and JPY as global funding currencies).

The increase in stock returns in response to an appreciation of the Euro is consistent with
results reported in Muller and Verschoor (2006b): the authors find that appreciating Euro against
foreign currencies had a positive effect on the returns of European stocks. They argue that Euro-
pean firms are mainly net-importers and thus benefit from a strong Euro which makes both
domestic consumption and exports of products, including materials supplied from overseas, more
competitive. The results in our paper differ from Campbell, Medeiros, and Viceira (2010) which
report a negative correlation between the European stock market and the Euro exchange rate for
the period from 1975 to 2005 from the perspective of an international investor. These results are
not inconsistent with ours, as Campbell, Medeiros, and Viceira (2010) use the US dollar as the
reference currency, whereas we use the Euro, so that in comparing directly the results for the
exchange rate between the Euro and the US dollar the results should be inverted. Indeed where
Campbell, Medeiros, and Viceira (2010) find a negative relationship between the exchange rate
expressed as the number of Euros per US dollar and their proxy for European stock markets
(comprising a portfolio that includes German, French, Italian and Dutch stocks), we find a pos-
itive relationship between the number of US dollars per Euro and the Euro Stoxx TMI. These
results are directly consistent, as our exchange rate is a direct inversion of the quotation con-
vention adopted in Campbell, Medeiros, and Viceira (2010). There are important differences
between the research question and approach in Campbell, Medeiros, and Viceira (2010) and
this paper. Campbell, Medeiros, and Viceira (2010) consider excess returns on equity portfolios
and currencies, whereas we adopt a procedure to procure unexpected (as opposed to excess)
returns; to check our results we conducted data transformations following Campbell, Medeiros,
and Viceira (2010) to obtain excess returns in the Euro exchange rate against the US dollar and
the Euro Stoxx and MSCI World index and obtained the same (negative) sign on the correlations
between these series as in Campbell, Medeiros, and Viceira (2010) for the total sample period.
Thus, our results should not be interpreted as inconsistent with those of Campbell, Medeiros, and
Viceira (2010), but have a common underlying result which is then used to consider somewhat
different aspects of the empirical relationship (in their case hedging in international investor port-
folios and in ours the impact of exchange rate fluctuations on the equity value of individual firms
involved in different underlying lines of business).

The percentage of firms with a significant response to unexpected exchange rate fluctuations
in the Euro Stoxx 50 sample is considerably higher than for the Euro Stoxx TMI (almost 43%
for the JPY, 26.5% for the USD, 20.41% for the GBP and 67.35% for the CHF). Given that the
Euro Stoxx 50 comprises the largest MNCs in Eurozone this result is unsurprising, although one
cannot directly compare the estimated βis across the two tables as the market indices for which
they are constructed differ. Table 3 reports that for the Euro Stoxx 50 constituents, the highest
average impact is from unexpected moves in the Euro against the CHF at almost 16.4% for every
10% exchange rate variation, followed by the GBP (9.5%), JPY (6.7%) and USD (5.9%).

4.1 The role of firm characteristics

A firm’s level of international involvement is a recognized determinant of its exchange rate
risk exposure. However, the sign, significance and magnitude of the exposure coefficients

120 F. Parlapiano et al.

are ambiguous. Choi and Jiang (2009) found evidence that the multinationality affects a
firm’s exchange exposure, however, this effect is not consistent with theoretical predictions.
Empirically, exchange rate risk exposures are smaller and less significant for MNCs than for non-
multinationals and this evidence may be the outcome of operational hedging which decreases a
firm’s exchange risk exposure and increases its stock returns. According to Davies, Eckberg,
and Marshall (2006), Bartram (2008) and Bartram, Brown, and Fehle (2009), there is strong
evidence indicating that firms with a higher proportion of international sales are more likely to
hedge FEE. Nevertheless, it is plausible that the effectiveness of these financial and operational
hedging strategies may be incomplete when future cash flows are considered. While hedging
strategies effectively mitigate current exposure in the short run (i.e. the transaction exposure),
the effectiveness of these hedging practices is weak in the long run (i.e. the economic exposure).
An alternative explanation offered by Amiti, Itskhoki, and Konings (2014) provides a theoretical
framework where the typical large importer is also a large exporter and hence manages both sides
of any exchange rate fluctuation, so that less internationally active firms are likely to experience
more exchange rate pass-through to prices than their more internationally focused counterparts.

Table 4 reports the exposure coefficients grouped by the level of international involvement as
approximated by the FEE index. A clear pattern emerges: low exporters and domestic firms are
more sensitive to unexpected exchange rate fluctuations than MNCs. In fact, the magnitude of
the average exposure coefficient of low exporters and domestic firms is greater, confirming the
findings in Davies, Eckberg, and Marshall (2006) and Choi and Jiang (2009). This result does
not support the theoretical premise that the greater the firm’s level of international involvement,
the greater the impact of currency fluctuations on firm’s market value. In contrast, our results
highlight the relevance of the exchange rate exposure to firms which do not report operations in
foreign currencies and the need for a better control of this risk. These results are consistent with
Amiti, Itskhoki, and Konings (2014), who provide Euro relevant evidence for reduced exchange
rate pass through for internationally active firms from Belgian data. Coupled with risk manage-
ment policies, these effects may explain why MNCs have less stock price response to exchange
rate exposure than low exporter firms.

The breakdown by the level of international involvement, given in Table 4, displays two
additional features: the combined proportion of low exporters and domestic firms significantly
affected by fluctuations of the Euro is larger than MNCs in the case of USD and GBP, while this
picture is reversed in the case of JPY and CHF. One possible explanation is that MNCs concen-
trate on hedging against risks from only their main trading partners’ currencies (e.g. USD and
GBP), while the CHF and JPY are simply overlooked. Another possible explanation could stem
from the use of foreign debt by European firms and the ability of these firms to raise capital by
borrowing from Swiss and Japanese institutions with unhedged loans denominated in JPY and
CHF; traditionally low yielding currencies (Brunnermeier, Nagel, and Pedersen 2008; Galati,
Healt, and Guire 2007; Hattori and Shin 2009).

When controlling for the level of international involvement, large capitalization firms are more
likely to be exposed to exchange rate risk. Consider, for example, that 43% of Euro Stoxx 50
MNCs are significantly affected by exchange rate fluctuations compared with 27% of Euro Stoxx
TMI MNCs (see Table 4).

Most of the existing literature has focused on industrial firms, assuming that the exposure
of financial firms may be driven by different aims and factors; particularly, the possibility of
taking advantage of better forecasts of future exchange rates by financial institutions. Here we
also include financial firms in our analysis. Estimates in Table 5 confirm that firms within the
financial industry experienced a much larger positive impact of exchange rate fluctuations than

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Table 4. Exchange rate exposure of European firms with a breakdown by international involvement.

JPY USD GBP CHF

MNCs Low export. Dom. MNCs Low export. Dom. MNCs Low export. Dom. MNCs Low export. Dom.

Euro Stoxx
TMI

Sample 340 82 71 340 82 71 340 82 71 340 82 71

Total
significance

27% 18% 24% 10% 16% 13% 10% 9% 13% 54% 40% 52%

Average β
(a)
s 0.77 0.87 0.85 0.47 1.00 0.76 0.47 1.10 0.91 1.90 1.90 1.72

(N +)β(b)s 87 15 17 27 13 9 24 7 9 182 33 27
(N −)β(c)s 4 7 9

Euro Stoxx
50

Sample 37 5 37 5 37 5 37 5

Total
significance

43% 40% 24% 40% 19% 40% 65% 80%

Average βs 0.69 0.92 0.65 0.89 0.89 1.21 1.64 1.60
(N +)βs 16 2 9 2 7 2 33 24
(N −)βs

Notes: Equation (4) estimated using monthly data from 1999 to 2011. Heteroskedasticity robust OLS estimates of the exchange rate exposure, β
is

, for the Euro Stoxx TMI and
the Euro Stoxx 50 constituents are reported along with the percentage of firms significantly affected by exchange rate fluctuations, the average magnitude of significant exposure
coefficients and the number of firms positively, N +, and negatively, N −, affected by currency variations. Each firm is grouped as MNCs, low exporters or domestic according
to the ratio of non-Eurozone revenues on total revenues.
Equation (4) estimated using monthly data from 1999 to 2011. Heteroskedasticity robust OLS estimates of the exchange rate exposure, βis , for the Euro Stoxx TMI and the
Euro Stoxx 50 constituents are reported along with the percentage of firms significantly affected by exchange rate fluctuations, the average magnitude of significant exposure
coefficients and the number of firms positively, N +, and negatively, N −, affected by currency variations. Each firm is grouped as MNCs, low exporters or domestic according
to the ratio of non-Eurozone revenues on total revenues.
(a)Average of significant βis from Equation (4).
(b)Number of significant and positive βis from Equation (4).
(c)Number of significant and negative βis from Equation (4).

122
F.

P
a
rla

p
ia

n
o

et
al.

Table 5. Exchange rate exposure of European firms with a breakdown by industry.

JPY USD GBP CHF

Financials(a) Non Financials(b) Financials Non Financials Financials Non Financials Financials Non Financials

Euro Stoxx
TMI

Sample(c) 83 446 83 446 83 446 83 446

Total
significance

49% 24% 35% 9% 20% 9% 72% 49%

Average β
(d)
s 0.90 0.79 0.82 0.58 0.99 0.58 1.90 1.88

(N +)β(e)s 41 101 29 33 17 31 60 219
(N −)β(f)s 4 7 9

Euro Stoxx
50

Sample 12 37 12 37 12 37 12 37

Total
significance

50% 41% 33% 24% 25% 19% 83% 62%

Average βs 0.67 0.67 0.44 0.66 1.02 0.93 1.75 1.60
(N +)βs 5 15 3 9 3 7 10 23
(N −)βs 1 1

Notes: Equation (4) estimated using monthly data from 1999 to 2011. Heteroskedasticity robust OLS estimates of the exchange rate exposure, β
is

, for the Euro Stoxx TMI and
the Euro Stoxx 50 constituents are reported along with the percentage of firms significantly affected by exchange rate fluctuations, the average magnitude of significant exposure
coefficients and the number of firms positively, N +, and negatively, N −, affected by currency variations. Each firm is grouped as financial or non-financial according to the
Bloomberg Industry Classification System.
(a)Financials include firms in financial, banking, and insurance sectors.
(b)Non-financials are composed of firms in Industrial, Utility and REIT sectors.
(c)The sample size is 529 firms from Euro Stoxx TMI. Securities with less than 70 observations have been excluded from the analysis.
(d)Average of significant βis from Equation (4).
(e)Number of significant and positive βis from Equation (4).
(f)Number of significant and negative βis from Equation (4).

The European Journal of Finance 123

Table 6. Exchange rate exposure of European firms with a breakdown by country.

AT BE DE ES FI FR GR IE IT NL PT Others(a)

Number of firms 23 40 85 39 43 100 47 15 79 37 14 7

JPY Proportion

significant
(%)

4 23 26 15 16 27 26 27 37 22 21 0

Average β
(b)
s 1.07 1.06 0.89 0.66 0.50 0.78 1.02 0.93 0.80 0.54 0.60 1.75

USD Proportion
significant
(%)

9 18 14 15 9 10 17 0 10 11 50 14

Average βs 0.80 0.83 0.76 0.70 0.33 0.39 1.18 0.67 0.09 0.68 1.08
GBP Proportion

significant
(%)

0 15 8 15 9 10 19 7 10 5 29 0

Average βs 0.49 0.84 0.91 − 0.93 1.03 1.44 − 3.61 0.81 − 0.19 0.88
CHF Proportion

significant
(%)

48 48 67 41 30 53 47 27 66 49 79 43

Average βs 2.09 1.72 2.17 1.40 1.75 1.74 2.40 2.35 1.64 1.93 1.72 2.33

Financials (%) 17 28 8 28 5 9 15 7 30 8 29 0
Non-financials (%) 83 73 92 72 95 91 85 93 70 92 71 100
MNCs (%) 75 47 76 51 81 82 40 100 51 86 73 100
Low exporters (%) 15 16 18 29 19 9 33 0 18 14 9 0
Domestic (%) 10 37 6 20 0 8 28 0 31 0 18 0

Notes: Equation (4) estimated using monthly data from 1999 to 2011. Heteroskedasticity robust OLS estimates of the
exchange rate exposure, βis , for the Euro Stoxx TMI are reported along with the percentage of firms significantly affected
by exchange rate fluctuations. Each firm is grouped according to the country of origin.
(a) Countries with less than five firms.
(b)Average of significant βis from Equation (4).

firms outside the financial industry. The proportion of financial firms significantly affected is
larger and, in most cases, more than double the proportion of non-financial firms and, in addition,
the magnitude of exposure coefficients is, on average, greater.

We next consider the sensitivity of firms to exchange rate risk by the firm’s country of origin
within the Eurozone; Table 6 presents the results. The list of countries relatively more exposed
to exchange rate fluctuations includes Greece, Ireland, Italy, Portugal, Spain (so-called GIIPS
countries) and Belgium. This result can be partially explained by examining the concentration
of financial firms in each of these countries. In fact, the ‘GIIPS’ countries, which experienced
sovereign default risk late in the sample, show the largest concentration of financial firms when
compared with other countries; as discussed before, firms in these categories have higher rates
of exposure to exchange rate risk (see Table 5). In a recent paper, Acharya and Steffen (2013)
provided evidence of a large ‘carry trade’ by European banks towards domestic sovereigns. By
accessing short-term unsecured funding in wholesale markets, banks appear to have undertaken
long peripheral sovereign bond positions. These carry trades were undertaken for the most part
by ‘GIIPS’ banks showing a form of home bias. We suggest that our result may provide some evi-
dence for the existence of spillovers between sovereign and corporate risk perception, although
this requires further investigation.

124 F. Parlapiano et al.

(a) (b)

Figure 1. Relationship between exchange rate exposure and the Eurozone stock market exposure. Using
quantile regression, we investigate the interdependence between estimated currency betas, β̂is, and
market betas, β̂im, where the exposure to market risk, as captured by the market beta, is the response
variable as in Equation (5). We plot OLS quantile regression estimated for τ ranging from 0.05 to 0.95 (the
solid dotted curve); in particular, each point measures the impact of a one-unit change of the currency beta
on the market beta. For each of the plots, the x axis has the quantile scale and the y axis as the response
variable scale. The two solid curves represent 95% confidence intervals of the estimated coefficients using
quantile regression. The dashed line in each plot shows OLS estimate of the conditional mean effect and
the two dashed dotted lines represent conventional 95% confidence intervals for the least squares estimates.

4.2 Relating market and exchange rate sensitivities

The empirical work carried out in this section has generated a pool of estimates of individual firm
sensitivities to market risk, βim, and exchange rate risk, βis. Using quantile regressions, we now
consider the extent to which these sensitivities may be related. If firms are simply more sensitive
to both types of shocks, then we would expect a monotonic relationship between these loadings.
We characterize quantiles, τ , of the conditional distribution of market betas as a function of
currency betas generated from the quantile regression framework between estimated currency
betas, β̂s, and market betas, β̂Mm , as follows:

β̂Mim = θ0 + θ1
(
β̂is

)
+ μi, (5)

where β̂Mim is the market risk exposure for a firm i and β̂is is the exchange rate risk exposure from
Equation (4). Figure 1 plots the estimated θ 1 for τ ranging from 0.05 to 0.95 (the solid dotted
curve), where the horizontal axis is the quantile scale and the vertical axis is the response vari-
able scale. In particular, each point measures the impact of a one-unit change in the currency

The European Journal of Finance 125

beta on the market beta, holding other covariate fixed. The two solid curves represent 95%
confidence intervals of the estimated coefficients using quantile regression. The dashed line in
each plot shows OLS estimate of the conditional mean effect and the two dotted lines represent
conventional 95% confidence intervals for the least-squares estimates.

It is clear that the relationship is not linear for any of the currencies considered. The lowest
quantile of β̂Mim (on the horizontal axis) is associated with the lowest exchange rate exposure
sensitivity – that is the figures all begin in the bottom left hand corner – representing that these
firms are simply insensitive to both types of risk. As sensitivity to market risks increases to
around the 50% quantile, the exchange rate sensitivity of firms also increases. Firms in this range
are more sensitive to both types of risk. More interestingly, post the 50% quantile, we typically
see a decline in the exchange rate exposure sensitivity of the firms. These firms are more sensitive
to unexpected market risk but less so to exchange rate risk. Potentially, this represents the finding
in the literature that some firms may not have detectable exchange rate exposure risk due to their
actions to hedge exchange rate risk.

Table 7. Exchange rate exposure of European firms (augmented market model of Jorion (1990)).

Market model type

Augmented Non-orthogonalized

Currency trend JPY ( − 12.05%)
Average β 0.30 0.20
Total significance 84 (15.88%) 33 (6.00%)
(N +)β 59 21
(N −)β 25 12
Currency trend USD (30.80%)

Average β 0.26 0.15
Total significance 72 (13.61%) 47 (8.88%)
(N +)βs 49 29
(N −)βs 23 18
Currency trend GBP (30.85%)

Average βs − 0.06 − 0.12
Total significance 61 (11.53%) 32 (6.05%)
(N +)βs 32 16
(N −)βs 29 16
Currency trend CHF ( − 24.38%)
Average βs 1.05 1.32
Total significance 60 (11.34%) 27 (5.10%)
(N +)βs 49 24
(N −)βs 11 3

Notes: Equations (1) and (4) estimated using monthly data from 1999 to 2011. Average β represents the average
of significant β1 from Equation (1) in the case of augmented model and the average of significant βis from
Equation (4) in the case of non-orthogonalized model. Non-orthogonalized market return and exchange rate return
have been employed in Equation (4). OLS estimates of the exchange rate exposure for the Euro Stoxx TMI
constituents are reported along with the percentage of firms significantly affected by exchange rate fluctuations,
the average magnitude of significant exposure coefficients and the number of firms positively, N +, and negatively,
N −, affected by currency variations.

126 F. Parlapiano et al.

4.3 Sensitivity analysis

The results reported in this paper support that a higher proportion of European firms are affected
by exchange rate risk than evidenced in the previous literature. As these studies largely follow a
Jorion (1990) style model, and do not account for potential collinearity, this may be a contributing
factor to the differing results. To explore this, we implement the Jorion model for our data sample
with the results reported in Table 7. We report the results for the Euro Stoxx TMI firms and these
can be compared with those reported in the first column of Table 3. For the JPY and CHF, the
estimated proportion of firms significantly affected by exchange rate risk using the Jorion (1990)
model is remarkably lower than that using the orthogonal market model implemented in this
paper; in the case of the USD and the GBP the proportion is almost the same. In all cases, the
average estimate of the relationship between individual firm equity return and exchange rate
risk, the βis, is larger with the orthogonal market estimates than the Jorion (1990) approach.
Notably, the average of the significant coefficients in the orthogonal market models are always
positive, in contrast to the varying results obtained using Jorion (1990) approach. To conserve
space, we omit the Euro Stoxx 50 results as the outcomes are consistent with those reported
(a full set of results are available from the authors on request).

The additional control variables in the orthogonal market model may also be playing a role. To
explore this aspect, we estimate Equation (4), but instead of using the orthogonalized market and
exchange rate shocks, we substitute these with the market returns and the exchange rate changes
directly – that is we omit the first two steps of the three step procedure. The results for the full
sample are presented in Table 7, and show that the proportion of firms affected by exchange
rate changes is uniformly smaller than in the orthogonal model implemented in Section 2 of this
paper, and the impact coefficients are smaller and not uniformly positive. The body of evidence
on the common factors which affect exchange rate and equity market conditions, coupled with the
difference that omitting to orthogonalize exchange rate and market shocks makes to the results,
supports the importance of controlling for potential collinearity using an orthogonalized model.

5. Concluding remarks

Previous works on firms’ exchange rate exposure have focused on the US markets and found that
the US dollar exchange rate fluctuations have weak effects on US stock returns. In light of the vast
empirical evidence, Bartram and Bodnar (2007) argue that the proportion of firms significantly
exposed is not as high as literature leads us to believe. This could be partially attributed to
failure to recognize reducing exchange rate exposure. If firms react rationally to the exposure
by undertaking operational and financial hedging actions, it is plausible that most firms are not
exposed. Alternatively, stock returns reflect only the residual exposure of firms, that is, net of
corporate hedging policies. The international evidence on currency exposure provided so far has
found significant results for just 10–25% of the cases (Bartram and Bodnar 2007).

This study investigates the exchange rate exposure of European firms accounting for the
joint influence of macroeconomic fundamentals on stock market and exchange rate returns.
The orthogonal market model approach proposed in Doukas, Hall, and Lang (2003) and later
in Priestley and Ødegaard (2007) is employed and the results are compared with the mainstream
augmented CAPM model of Jorion (1990).

We examine the three major trading partners of the Eurozone by analyzing the impact of fluc-
tuations in the Euro exchange rate against the US Dollar, British Pound and Japanese Yen on the
value of European firms. In addition, we include the Swiss Franc in our analysis due to close

The European Journal of Finance 127

geographical and economic relationships between the Eurozone and Switzerland and the CHF’s
role as a safe-haven currency. We find that 11–52% of the Euro Stoxx TMI constituents are sig-
nificantly affected by exchange rate fluctuations. When compared to the results of other studies,
our estimates exceed previous findings reported in Muller and Verschoor (2006b), Bartram and
Karolyi (2006), Nguyen, Faff, and Marshall (2007), Hutson and O’Driscoll (2010) and Inci and
Lee (2014). We also observe that among the currency pairs analyzed the CHF had the highest
impact on the returns of the European firms, with the greatest impact on the firms in the financial
sector and firms with large capitalization.

We find that stock returns react positively to the Euro appreciation during 1999–2011; our
results are consistent with the investor portfolio results based on excess returns in equities and
exchange rates in Campbell, Medeiros, and Viceira (2010) once we control for the quotation
convention. Segmenting the results by level of internationalization reveals that domestic firms
appear more exposed than MNCs, highlighting the need for a better corporate management of
exchange rate risk by these firms. As expected, firms operating in the financial sectors system-
atically experience greater exposure to exchange fluctuations both in terms of magnitude and
percentage of firms significantly exposed. The country breakdown of the firms reveals differ-
ent impact of exchange rate fluctuations on these Eurozone national stock markets. In countries
that experienced sovereign debt crisis and countries where the concentration of financial firms is
larger we observe greater exchange risk exposure.

Our results suggest that domestic firms are more vulnerable to unexpected exchange rate fluc-
tuations than MNCs. This presents an opportunity for further research with appropriate controls
for differences in risk management policies of firms.

Acknowledgments

We thank Giovanni Palomba, participants at the fifth International Risk Management Conference and two anonymous
referees for helpful comments and discussion in improving the paper. This work was made possible by the facilities of
the University of Cambridge Judge Business School – Center for Financial Analysis & Policy.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. The number of constituents of the Euro Stoxx TMI varies to coverage of approximately 95% of the free-float mar-
ket capitalization of the European Monetary Union, while the Euro Stoxx 50 covers 60% of the free-float market
capitalization of the Euro Stoxx TMI super sector index.

2. Data sources and construction: we initially followed Fama and Gibbons (1984) to obtain measures of expected and
unexpected inflation. However, the low volatility of inflation within the Eurozone meant that their approach was not
appropriate for this sample. We considered three alternative proxies for expected inflation: (i) world oil price inflation
(as approximated by the West Texas Intermediate); (ii) the European Central Bank survey of professional forecasts;
and (iii) the previous month’s realized inflation, respectively. The results led us to the prefer lagged realized inflation,
consistent with the approach of Gao (2000), who employs realized inflation rate as a control variable in identifying
unexpected exchange rates variation. Industrial production and money supply are measured as percentage growth
rates, the term premium is the 10 year government bond less 3 month note yield, the international interest rate
differential is the 3 month spread and trade balance is the log difference between exports and imports. Most data
are sourced from the European Central Bank, with the exception of the term premium and interest rate spread data
which are calculated from Datastream series.

128 F. Parlapiano et al.

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© 2015 Wiley Periodicals, Inc.
Published online in Wiley Online Library (wileyonlinelibrary.com).
DOI 10.1002/jcaf.22031

by the treasury function. Those
challenges and some important
information technology (IT)
security and compliance con-
siderations are presented in this
article.

Because smaller organiza-
tions may lack the resources for
full and complete cybersecurity,
the article is written primarily
for the treasurers of the small or
midsized organizations. But any

John A. Pendley

Information Security and Cloud-Based
Computing: Tools for the Corporate

Treasurer

C
orporate treasur-
ers are responsible
for a great variety

of activities. In addi-
tion to policymaking
roles, treasurers may
also be responsible
for certain day-to-day
activities, particularly
those related to cash
management and
investment policy. For
example, some treasur-
ers are responsible for
the management of
customer invoicing, bill
payment, cash trans-
fers, and securities pur-
chases and sales. With
such a wide breath of activities,
it seems overkill to add informa-
tion security to the mix. But,
unfortunately, such must be the
case in today’s information pro-
cessing environment.

This article describes cyber-
security issues for the financial
treasurer. The treasurer faces
some unique challenges because
of the low-volume, high-value
transactions typically handled

financial manager
involved in treasury-
related functions
should have a work-
ing knowledge of
data security basics.

ARE YOU
PREPARED?

Many types
of data routinely
handled by treasury
departments are
vulnerable to data
loss or compromise.
Cash transfers are
routinely made in
order to manage

cash balances and ensure the
availability of funds across the
organizations’ functions. These
transfers involve important and
sensitive data, including account
numbers, passwords, transaction
identifiers, and routing numbers.

Many treasurers oversee
investments and manage debt.
To do so requires the execution
of securities transactions
that involve accounts, fund

This article describes cybersecurity issues for
the financial treasurer. Although job descriptions
for corporate treasurers probably don’t mention
systems and information security, many treasury
services are now digitized, which raises the risk
of information being compromised by hackers,
malware, or computer viruses. In this information
technology (IT) environment, treasury officials are
increasingly being asked to justify the steps being
taken to secure and control the electronic trans-
actions and digitized data under their jurisdiction.
This article will help by describing practices and
tools available to secure modern financial pro-
cessing systems from unauthorized access.
© 2015 Wiley Periodicals, Inc.

28 The Journal of Corporate Accounting & Finance / March/April 2015

administration, or control of
the web environment. These
situations mean that the secu-
rity of treasury information
may be neglected.

When technical expertise is
lacking, as it is in many small
organizations, the treasurer can
take some basic steps to cre-
ate a more secure environment.
Exhibit 1 contains some funda-
mental best practices for data
security.

TOOLS AND SERVICES

Often, more comprehen-
sive solutions are needed. The
department may engage in
complex transactions that are
executed across multiple IT
environments, or cloud-based
systems may be employed.
In these situations, a third-
party consultant or software
services company should be
employed.

The list in Exhibit 2 is given
as a starting point. These com-
panies are vetted for the list as
follows:

1. The company is a major
sponsor for the informa-
tion security conference
Black Hat USA 2014.
Black Hat (www.blackhat
.com) has organized
information security
conferences in the United
States and internationally
for 16 years. It is well
known in the cybersecurity
industry for meetings and
information sharing.

2. Products for SMEs are
described on the company’s
website. This means that
the company markets prod-
ucts and services specifi-
cally for smaller organiza-
tions. The company will
likely have comprehensive
security products created

Treasurers must also be
aware of a wide variety of
cybersecurity laws and regula-
tions that cover the data being
processed. Laws such as the
Health Insurance Portability and
Accountability Act (HIPAA;
health information privacy),
Dodd-Frank (financial system
regulation), Sarbanes-Oxley
(financial reporting and internal
controls), and industry security
standards such as the Payment
Card Industry Data Security
Standard (PCI-DSS) may apply
to data generated or processed
by treasury. Privacy laws and
cybersecurity regulations cover
all sensitive data, but most affect
financial systems that use the
Internet heavily or are imple-
mented in virtual environments
(i.e., in the cloud). Compliance
issues are complex and should
be considered carefully based on
the industry and function of the
organization and the breadth of
the treasurer’s duties.

It must be mentioned that
most treasurers do not handle
these issues alone. If a company
has a dedicated IT security
staff, a good system of IT gov-
ernance, and an effective IT
audit function, the company
likely possesses the expertise
to protect financial informa-
tion assets and comply with
applicable regulations. But
many treasurers do not enjoy
the day-to-day support of sig-
nificant information security
expertise. In particular, many
small and medium sized busi-
nesses, governmental units, and
nongovernmental organizations
(NGOs) cannot afford in-house
cybersecurity specialists.

Even in larger companies
that employ security special-
ists, their time may be devoted
to other areas such as overall
enterprise security, software
change control, network

identifiers, and serial numbers.
Payment systems, another trea-
sury function in many organiza-
tions, can contain credit card
numbers, security codes, and
customer and vendor data. All
of this information is subject
to threats, such as malware and
data loss, and is affected by com-
pliance issues, such as privacy
and security laws.

Malware established in
treasury systems can quickly
compromise significant amounts
of high-value information. To
protect in-house systems and
networks, a firewall is typically
created to protect the company’s
information assets. However,
breaches can occur when unau-
thorized software (that can
contain malware) is introduced
behind the firewall. Thus, when
employees download and install
personal software, open personal
e-mail, click on e-mail attach-
ments, surf personal sites at
work, or leave applications open,
malware can be introduced and
gain a footing in the system.

Many companies are lever-
aging advanced technologies,
such as cloud computing, to
cut costs and gain competitive
advantage. Considerable strides
have been made in the security
aspects of cloud-based systems.
For example, an industry
consortium called the
Cloud Security Alliance has
organized and published
(www.cloudsecurityalliance.org)
information about the advance-
ments made in cloud-based data
security. Challenges continue to
exist particularly with respect to
sporadic episodes of data loss
and the possibility of denial-of-
service attacks. However, with a
reputable cloud-based provider
(and good firm-based enterprise
security), cloud computing can
be an effective and secure method
of processing financial data.

The Journal of Corporate Accounting & Finance / March/April 2015 29

Fundamental Best Practices for Information Security

For in-house systems:

• Install security software that creates a firewall and provides malware protection. Keep the profiles up to
date.

• Create a standard security configuration for browsers and e-mail software. Establish a policy to prevent
alterations to the standard configuration.

• Establish policies concerning using and configuring other software and installing new programs.
• For centralized accounting software, create authorization layers and associated passwords and assign a

responsible employee to review security reports.
• Backup files frequently. Consider automating the process. If the organization does not have a business

continuity plan, consider starting one.

For web-based financial systems and cloud-based environments:

• Analyze the data communicated over proprietary systems or stored in cloud-based environments. Con-
sider laws and regulations that apply to the information and ensure that you are in compliance with all
privacy and security provisions for the data being transmitted or stored.

• In a cloud-based environment, make sure that sensitive data are encrypted using an established and
secure algorithm and that proper controls are maintained over the encryption keys.

For any environment:

• If you (or your firm) lack the in-house technological expertise, contact an outside expert to conduct a
security review (see Exhibit 2 for some suggestions).

• Learn more. The Department of Homeland Security, for example, maintains web resources that are a good
starting point for learning about cybersecurity. See www.dhs.gov.

Exhibit 1

Companies That Can Provide Conventional and Cloud-Based Data Security Solutions

Company Product and Services Site

KPMG LLP Risk management consulting services www.kpmg.com

Mandiant Security consulting and incident response www.mandiant.com

SecureWorks A Dell subsidiary that provides a variety of information
security services

www.secureworks.com

Trustwave Comprehensive security, data protection, and risk
management services

www.trustwave.com

Verdasys Cloud-based security products www.verdasys.com

Watchguard Integrated information security and threat management
solutions for small and medium-sized enterprises
(and larger organizations)

www.watchguard.com

Exhibit 2

30 The Journal of Corporate Accounting & Finance / March/April 2015

controls should cover three
areas:

• Prevent of data
breaches,

• Eliminate data loss, and
• Comply with cybersecurity

and privacy laws and
regulations.

traditional financial controls
over treasury department trans-
actions. Physical security of
assets, segregation of duties,
and cash controls are common
and well understood. What is
described in this article is add-
ing a set of IT and cybersecu-
rity controls to the mix. These

for and priced for that
market.

CONCLUSION

Because of the nature of
treasury operations, most orga-
nizations have a strong set of

John A. Pendley is Associate Professor of Accounting at the Sigmund Weis School of Business at Susque-
hanna University, in Selinsgrove, Pennsylvania. He can be reached at pendley@susqu.edu .

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