Moving to International Arena

 More and more firms around the world are going

global, including:
 Service companies (i.e. banks, insurance, consulting firms)
 Manufacturing firms such as the car makers
 Art, film, and music companies
 International firms tend to be organized as
corporations: These firms are normally referred to
as multi national corporations (MNCs)
 In the following, we use international firms and MNCs
interchangeably.
1 1
 Top 10 MNCs in 2021 by Revenue
1 Walmart United States
2 State Grid Corporation of China China
3 Amazon United States
4 China National Petroleum Corporation China
5 Sinopec Group China
6 Apple United States
7 CVS Health United States
8 UnitedHealth Group United States
9 Toyota Motor Japan
10 Volkswagen Germany
1-2
2
Advantages for a Firm Stepping into
International Arena
 Expanded Opportunity Set
 By conducting business on a global basis, firms benefit from
the expanded opportunity set, e.g., the larger customer base.
 Low marginal costs from knowledge advantage
 Managerial and marketing knowledge developed at home
can be used abroad with low marginal costs.
 Regulatory advantage
 An international firm, and in particular an international bank,
is sometimes not subject to the same regulations as a
domestic firm.
3
 International Banking and
Offshore Banking
 International banking is a good example that
illustrates all these advantages.
 Today, major U.S. banks have all established
branches at foreign countries that allow them to
bypass regulations imposed by the U.S.
government.
 Offshore banking is a special type of international
banking: It means a bank moves part of its
business to the so-called offshore centers.
1-4
4
Offshore Centers and Offshore Banking
 An offshore center is a small, low-tax country or region
(sometimes referred to as “tax heaven”), whose banking
system is organized to permit external accounts beyond
the normal economic activity of this country or region.
 For example, the branch of a U.S. bank at HK can make dollar-
denominated loans and offer dollar-denominated funds.
 The International Monetary Fund (IMF) recognizes the
Bahamas, the Cayman Islands, Panama, Hong Kong,
Singapore, and the Netherlands Antilles as major
offshore banking centers
1-5
5
 More Risks for an MNC:
Political Risk
 Political Risk: Sovereign governments have the
right to make their own politically-calculated
decisions, which may inadvertently affects the
international businesses for MNCs.
 In 1992, a U.S. energy company signed a contract
to build India’s largest power plant
 After spending nearly $300 million, the U.S. company
found the project being cancelled in 1995 by the local
Indian politicians arguing that India didn’t actually
need this plant. 1-6
6
 More Risks for an MNC:
Market Imperfections
 Market Imperfections refer to a variety of frictions
and impediments, many of which are imposed by the
government, that prevent markets from functioning
efficiently
 An important type of market imperfections is the

trade barrier. Examples of trade barrier include

tariffs, quotas, bureaucracy, and other restrictions on
the free flow of goods, services, and people.
 Trader barrier makes it more difficult for MNCs,
particularly those which rely on foreign sales, to operate. 1-7
7
 More Risks for an MNC:
Foreign Exchange Risk
 The most common risk that an MNC faces for
doing international business is the so called
foreign exchange risk.
 To understand foreign exchange risks, we need to
first understand the exchange rate.
 What is exchange rate?
 Example: Hong Kong dollar v.s. U.S. dollar
 Generally, the exchange rate is the rate at which
we convert one currency into another currency.
8
 Historical Exchange Rates

9
 Foreign Exchange Risk
 Firms or individuals doing international business
are facing the so called foreign exchange risk: the
risk that foreign currency profits may evaporate in
dollar terms due to unfavorable exchange rate
movements.
 Consider the scenario where an American invests
in Japanese equity market.

10
 Foreign Exchange Risk
 Suppose right now the exchange rate is $1 =
¥100, and the American investor buys one share
of Toyota at ¥10,000 per share.
 Suppose one year later, the share price rises to
¥11,000. What is percentage loss/gain for the
American investor in terms of ¥?

11
 Foreign Exchange Risk
 Suppose one year later the exchange rate changes
to $1 = ¥120
 What is percentage loss/gain for the American
investor in terms of dollar?

12
 Foreign Direct Investment
 An important type of international business is
called the foreign direct investment (FDI) which
often involves the establishment of production
facilities abroad.
 FDI can either the take the form of building new
facilities from the ground up, or the form of cross-
border acquisition of an existing foreign business.

15-13
13
Reasons for FDI: Market imperfections
 By restricting the free flow of goods, services, and
people, market imperfections play an important
role for MNCs’ decisions on whether to conduct
FDI or not.
 Because of market imperfections, and particularly

because of trade barriers imposed by the govern-

ment, many MNCs have no other choice but to
move part of its production facilities to a foreign
country.
1-14
14
 Reasons for FDI: Trade Barrier
 For example, Honda, a Japanese automobile
company, decided to establish production
facilities in the U.S. mainly to circumvent the
trade barriers by the U.S. government.
 Cars directly imported from overseas will be
imposed high tariffs, whereas cars manufactured
within the U.S. will not.

1-15
15
 Reasons for FDI: Labor Costs
 Among all markets, the labor market is the least
perfect. In general, there exits strong restrictions
on the flow of workers across national borders. As
a result, labor costs or salaries can differ
dramatically across different countries.
 The restrictions may be immigration barriers or simply
social preferences.

15-16
16
Labor Costs around the Globe (2020)
Average Annual Average Annual
Country Wages ($) Country Wages ($)
Belgium $52,261 Japan $42,374
Sweden $48,784 Korea $34,961
U.K. $47,480 Israel $46,985
Australia $60,242 Spain $30,259
Canada $53,885 Greece $19,497
Italy $31,924 Brazil $6,032
France $43,418 Mexico $8,384
U.S. $69,392 China $10,642
Germany $48,4567 15-17
17
 Labor Costs: China vs. US
 The huge salary gap between China and the U.S. provides
incentives for the U.S. MNCs to move their factories and
production facilities to china to exploit the cheap labor.
 In many cases, the U.S. MNCs need to ship products back to the
U.S. Accounting for the shipping and the associated costs, they
still make more money than the case that they keep the business
within the U.S.
 The following link refers to an interesting video talking
about labor cost discrepancy between China and the U.S.:
https://www.youtube.com/watch?v=Mtf2H4YrYVw
15-18
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 Sources and Recipients of FDI
 Several developed nations are the sources of FDI
outflows.
 Most world-wide FDI comes from the developed world.
 Some developing countries, like China, have begun to
undertake FDI abroad, albeit on a modest scale.
 Both developing and developed nations are the
recipient of inflows of FDI.
 In the previous example that Hondo establishing
production facilities in the United States: U.S. is the
19
recipient of FDI. 15-19
 International Trade
 International trade refers to the exchange (import
or export) of raw materials, manufactured goods,
and services across national borders.
 Unlike FDI, MNCs engaging international trade
do not necessarily have production facilities in the
foreign country.
 The trade between China and US started as early as late
1970s, yet the FDI from China to the US started much
later.
20
 Theory for International Trade
(Deeper Issue)
 Proposed by David Ricardo in 1817, Theory of
comparative advantage says it is mutually beneficial
for countries if they specialize in the production of
these goods they can produce more efficiently
 The policy implication of Ricardo’s theory is clear:
liberalization of international trade.

21
 International Trade:
NAFTA and USMCA
 The North American Free Trade Agreement
(NAFTA) signed in 1994 calls for phasing out
impediments to trade among Canada, Mexico and the
United States over a 15-year period.
 The United States–Mexico–Canada Agreement

USMCA) is the result of a 2017–2018

renegotiation of NAFTA by its member states,
which informally agreed to the terms on September
30, 2018, and formally on October 1
22
 International Trade:
the European Union (EU)
 On the regional level, the European Union (EU) is
a better-known and also a prime example for
liberalization of international trade.
 Today, all 27 member states within EU have eliminated
barriers to the free flow of goods, capital, and people
 TheEU model is more than free trade: it is actually the
economic and financial integration.
 The member states of the EU hope this move will
strengthen its economic position relative to the U.S.

23
 International Trade: WTO
 WTO represents liberalization of international
trade at the International level.
 After 15 years of arduous efforts, China formally
became the 143rd member of the WTO on
December 11, 2001.
 China’s WTO membership has further legitimized
the idea of free trade.

24
 International Trade: TPP
(Not in PS or Exam)
 Started in 2010, Trans-Pacific Partnership (TPP) is
regarded by some economics as the upgraded
version of WTO.
 Unlike WTO which focuses on lowing tariffs, TPP targets
comprehensive market access.
 When he took the office, Donald Trump withdraw
the U.S. from the TPP on 23 January 2017.
 On 17 September 2021, China has officially applied
to join TPP (its current version being CPTPP).
25
 International Trade: RCEP
(Not in PS or Exam)
 The Regional Comprehensive Economic Partnership (RCEP) is
a free trade agreement in the Asia-Pacific region between the
ten member states of the Association of Southeast Asian
Nations (ASEAN) and their five partners (China, Japan, South
Korea, Australia, and New Zealand)
 RCEP was signed on 15 November 2020 at a virtual ASEAN
Summit, and it takes effect on 1 January 2022.
 The 15 member countries of RCEP account for about 30% of
the world's population, 30% of global GDP, and about one
third of world trade, making it the biggest trade bloc in history.
 .
26
 Foreign Exchange Market: Outline
 Overview of the Foreign Exchange (FX) Market
 Exchange Rate Quotations that involves USD

 Cross Rate

 Law of One Price (LOOP) and Arbitrage

 Triangular Arbitrage

27
 Foreign Exchange (FX) Market
 Foreign Exchange (FX) market exists because
people want to convert the purchasing power at
one country into the purchasing power at another
country.
 Virtually anything that has an international involvement
will result in a trade at the FX market.
 FX market is the largest financial market, and it is
open somewhere in the world almost 365 days a
year and 24 hours a day
28
 Circadian Rhythms of the FX Market
Electronic Conversations per Hour Time (0100-2400)
average peak hours, Greenwich time
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1:00 3:00 5:00 7:00 9:00 11:00 13:00 15:00 17:00 19:00 21:00 23:00
10 amin Lunch Europe Asia Lunch Americas London New 6 pmin
Tokyo hour in coming in going out hour in coming in going out Zealand NY
Tokyo London coming in

29
 Spot Market
 Spot market is also called the cash market, in
which commodities and securities bought and sold
are delivered immediately.
 Another market is called forward market, in which

commodities and securities will not be delivered

until at some future dates.
 The following discussion is focused on the spot

foreign exchange market.

30
 FX Market Participants
 Five groups of market participants
 International banks
 Bank customers
 Multinational corporations (MNCs), money managers, private
investors, etc.
 Nonbank dealers
 Mutual funds, Pension funds, Hedge funds
 FX brokers
 Central banks
 Central bank intervention: the process of using foreign exchange
reserves to buy (sell) one’s own currency in order to decrease
(increase) its supply and thus increase (decrease) its value in the FX
market.

31
FX Market Being a Two-tiered Market
 The FX market is a two-tiered market:
 Client Market (Retail): services provided by
international banks to their bank customers, which
accounts for 14% of FX trading volume.
 Interbank Market (Wholesale): trades among
international banks, nonbank dealers, and central banks,
which accounts for 86% of FX trading volume.

32
 Currency Symbols and codes
 Symbols and three-letter codes for currencies that
are often mentioned
 Symbols: £, ¥, €, $, HK$, AU$
 Codes:
GBP British pound
JPY Japanese yen
EUR euro
USD U.S. dollar
HKD Hong Kong dollar
CNY Chinese yuan

33
 U.S. Dollar and Exchange Rate
 In many cases, the quotation of exchange rates
involve the U.S. dollar ($).
 $ has been the dominant global currency since the
end of WWII
 International trade in primary commodities is normally
conducted using $ as the invoice currency.
 Dollar-denominated assets are treated as the major foreign
reserves by many countries.
 Consequently, people routinely quote a non-dollar
currency against $.
34
 Exchange Rate Quotations
that Involves USD
 Let’s start with quotations that involve USD.
 In general, exchange rate quotation can involve any two
currencies.
 The fundamental point: figure out what the
underlying currency is. Then, the other currency is
used to evaluate the underlying currency.

35
 Exchange Rate Quotations:
American Terms vs. European Terms
 The price of foreign currency in terms of the U.S.
dollar, referred to as American terms
 e.g., €1 for $1.25, or $1.25/€.
 The non-dollar currency is the underlying currency
 The price of the U.S. dollar in terms of the foreign
currency, referred to as European terms
 e.g., $1 for ¥120, or, ¥120/$
 In this case, the USD is the underlying currency

36
 Exchange Rate Quotations:
the European Terms
 Note although it is called the “European terms” by
convention, the foreign currency does not have to
be a European currency.
 For example, the familiar quotation of $1 for 7.8 HKD
is quoted in European terms.

37
 Exchange Rate Quotations:
American Terms vs. European Terms
 The reciprocal relationship between American and
European quotation :

S (non-dollar currency / $)
1

S ($ / non-dollar currency)

 Taking reciprocal just changes the underlying

currency.
38
 Exchange Rate Quotations
that Involves USD
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.0103 0.0103 96.9030 96.8776
Australia (Dollar) 0.7355 0.7408 1.3596 1.3499
Brazil (Real) 0.1915 0.1934 5.2217 5.1699 British pound
Britain (Pound) 1.3873 1.3930 0.7208 0.7179 quoted in
1 Month Forward 1.3873 1.3931 0.7208 0.7178
American
3 Months Forward 1.3875 1.3933 0.7207 0.7177
6 Months Forward 1.3879 1.3937 0.7205 0.7175
terms
Canada (Dollar) 0.7966 0.7996 1.2553 1.2506
1 Month Forward 0.7965 0.7996 1.2555 1.2506 £1 = $1.3873
3 Months Forward 0.7965 0.7995 1.2555 1.2508
6 Months Forward 0.7965 0.7996 1.2555 1.2506

39
 Exchange Rate Quotations
that Involves USD

Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
British
Argentina (Peso) 0.0103 0.0103 96.9030 96.8776 pound
Australia (Dollar) 0.7355 0.7408 1.3596 1.3499
quoted in
Brazil (Real) 0.1915 0.1934 5.2217 5.1699
Britain (Pound) 1.3873 1.3930 0.7208 0.7179
European
1 Month Forward 1.3873 1.3931 0.7208 0.7178 terms
3 Months Forward 1.3875 1.3933 0.7207 0.7177
6 Months Forward 1.3879 1.3937 0.7205 0.7175 £0.7208 =
Canada (Dollar) 0.7966 0.7996 1.2553 1.2506
$1
1 Month Forward 0.7965 0.7996 1.2555 1.2506
3 Months Forward 0.7965 0.7995 1.2555 1.2508
6 Months Forward 0.7965 0.7996 1.2555 1.2506

40
 Exchange Rate Quotations
that Involves USD
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.0103 0.0103 96.9030 96.8776
Australia (Dollar) 0.7355 0.7408 1.3596 1.3499
The American
Brazil (Real) 0.1915 0.1934 5.2217 5.1699
Britain (Pound) 1.3873 1.3930 0.7208 0.7179 term quotation
1 Month Forward 1.3873 1.3931 0.7208 0.7178 is the reciprocal
3 Months Forward 1.3875 1.3933 0.7207 0.7177
of the European
6 Months Forward 1.3879 1.3937 0.7205 0.7175
Canada (Dollar) 0.7966 0.7996 1.2553 1.2506
term quotation:
1 Month Forward 0.7965 0.7996 1.2555 1.2506
1.3873=1/0.720
3 Months Forward 0.7965 0.7995 1.2555 1.2508
8
6 Months Forward 0.7965 0.7996 1.2555 1.2506

41
 Two Ways of Writing Quotations
 Two equivalent ways of writing quotations:
Currency B/currency A, or equivalently,
Currency A.Currency B, where A is the underlying
currency.
 For example, both HKD/USD and USD.HKD

means that USD is the underlying currency, and

use HKD to evaluate USD.

42
 Cross Rates
 A cross-exchange rate is an exchange rate between a
currency pair where neither currency is the U.S.
dollar
 Suppose that S($/€) = 1.20
 i.e. $1.20 = €1.00
 and that S($/ £) = 1.50
 i.e. $1.50 = £1.00
 What is the implied cross rate for €/£?

43
 Cross Rates
 In general terms, suppose j and k denote two
different foreign currencies, then the implied cross
rates are computed as:
S(j/k) = S($/k) × S(j/$)
S(k/j) = S(k/$) × S($/j)
 In dealer jargon, a nondollar trade such as trading out

of £ into € is referred to as currency against currency

44
 The Cross-Rate Trading
(Deeper Issue)
 Most interbank transactions for currency against
currency trading goes through $.
 Take the trade of selling £ for € for example. The bank
will frequently handle this trade by first selling £ for $,
and then selling $ for €
 Why not sell £ directly for €?

45
 The Cross-Rate Trading
(Deeper Issue)
 Consider a total of six currencies (including the
U.S. dollar). If all transactions are through the
trading of the US dollar, only five trading desks are
needed, each of which is for trading one of the
nondollar currencies against the U.S. dollar.
 If each of the six currencies was traded directly with

each other, the dealing room would need to

accommodate 15 trading desks!

46
 Triangular Arbitrage
 Certain banks specialize in making a direct
market between two nondollar currencies.
 If their direct quotes are not consistent with the
implied cross-exchange rates, a triangular
arbitrage profit is possible.
 More generally, what is arbitrage? To answer it,
we need to start with “the law of one price” as a
fundamental economic law.

47
 Law of One Price and Arbitrage
 law of one price (LOOP): Ignoring any associated
market frictions, the same or equivalent assets or
commodities are trading at the same price across
different markets
 In finance, arbitrage refers to the act of
simultaneously buying and selling the same or
equivalent assets or commodities for the purpose
of making certain, guaranteed profits

48
 Violation of Law of One Price
and Its Restoration
 When the law of one price is violated, i.e., two
identical or equivalent assets are traded at
different prices, one can devise an arbitrage
strategy to make profits.
 The big idea is: buy at the lower price, and
immediately sell at the higher price without taking
any risks.

Associated with the exploitation of arbitrage
opportunities, the two prices will converge quickly.
49
 Examples of Arbitrage
 International commodity arbitrage
 Suppose the same car is sold at a higher price in Canada
than in the U.S. An American can take advantage of this
price difference by buying the car in the U.S. and selling it
in Canada
 Global labor arbitrage
 In manufacturing sectors, an average Chinese worker has
lower wage per unit of output than an average American
worker. A U.S. corporation can take advantage of this wage
difference by moving manufacturing jobs from the U.S. to
China, which is usually referred to as “outsourcing”
50
 The Persistent Violation of LOOP
 What are the possible reasons for the persistent
violation of LOOP?

Market segmentation
 Transaction costs

51
 Triangular Arbitrage

Suppose we
$
observe these
Barclays
banks posting Credit Lyonnais
these exchange S(¥/$)=100
S($/£)=2.00
rates.

¥ Deutsche Bank
Is there any £
arbitrage S(¥/£)=210
opportunity?

52
 Triangular Arbitrage:
Compute the Implied Cross Rate
$
Barclays
Credit Lyonnais
S(¥/$)=100
S($/£)=2.00

First we calculate ¥ Deutsche Bank £

S(¥/£)=210
the implied cross
rate between ¥ and
£ $2.00 ¥100 ¥200
× =
£1.00 $1.00 £1.00
53
 Triangular Arbitrage:
Identify the Arbitrage Opportunity
The implied S(¥/£) cross
rate is ¥200/£. $
Barclays
Credit Lyonnais
S(¥/$)=100 S($/£)=2.00
Deutsche Bank has
posted a direct quote of
S(¥/£)=210, a violation ¥ Deutsche Bank
£
of LOOP! S(¥/£)=210

So, how to devise an arbitrage strategy to make money?

Buy the £ @ ¥200 (buy low); sell £ @ ¥210 (sell high).
54
 Triangular Arbitrage:
Implement the Arbitrage Strategy
As easy as 1 – 2 – 3:
$
1. Sell ¥ for $, Barclays
Credit Lyonnais
2. Sell $ for £, S($/¥)=1/100 1 2 S($/£)=2.00
3. Sell £ for ¥ at ¥210/ 3
£ ¥ Deutsche Bank
£
S(¥/£)=210

The combining effects of 1+2 is to sell ¥ for £

at the implied cross rate, i.e., Buy the £ @ ¥200
55
 Triangular Arbitrage:
Starting by Selling Yen
Sell ¥10,000,000 for $ at S(¥/$) = 100
receive $100,000
Sell $100,000 for £ at S($/£) = 2.00
receive £ 50,000
Sell £ 50,000 for ¥ at S(¥/£) = 210
receive ¥10,500,000
profit per round trip = ¥ 10,500,000– ¥10,000,000 =
¥500,000
56
 Triangular Arbitrage: a Different
Starting Point
In fact, we can start
anywhere and still $
make money so long as Barclays Credit Lyonnais
we go “clockwise” S($/¥)=1/100
3 1 S($/£)=2.00
2
¥ Deutsche Bank
£
S(¥/£)=210

57
 Triangular Arbitrage:
Starting by Selling Dollar
Sell $100,000 for £ at S($/£) = 2.00
receive £50,000
Sell our £50,000 for ¥ at S(¥/£) = 210
receive ¥10,500,000
Sell ¥10,500,000 for $ at S(¥/$) = 100
receive $105,000
profit per round trip = $105,000 – $100,000 = $5,000

58
 Triangular Arbitrage

However, if we went
“counter clockwise” we $
would be the source of Barclays
Credit Lyonnais
arbitrage profits, not S(¥/$)=100 S($/£)=2.00
the recipient!
I leave it as an exercise ¥ Deutsche Bank
for you. £
S(¥/£)=210

59
 Triangular Arbitrage
 In equilibrium when there is no arbitrage, the
direct quote between ¥ and £ must be equal to the
corresponding cross rate between ¥ and £--- the so
called “no arbitrage” argument.

60