INTERNATIONAL BUSINESS AND TRADE a.
A country’s price inflation
Chapter 8 – The Foreign Exchange Market
Foreign Exchange Market
- a market for converting the currency of one
country into that of another country.
Exchange Rate
- the rate at which one currency is converted into
another.
Purpose/Functions of the Foreign Exchange Market
1. Enables the conversion of the currency of one country
into the currency of another.
2. Provides some insurance against foreign exchange risk
- the adverse consequences of unpredictable changes in
exchange rates.
Spot Exchange Rate
- the rate at which a foreign exchange dealer
converts one currency into another currency on a
particular day.
Forward Exchange Rate
- the exchange rate governing a transaction in
which two parties agree to exchange currency and
execute the deal at some specific date in the future.
Currency Swap
- the simultaneous purchase and sale of a given
amount of foreign exchange for two different value
dates.
Nature of the Foreign Exchange Market
1. The foreign exchange market is a global network of
banks, brokers, and foreign exchange dealers connected
by electronic communications systems.
2. The market is always open somewhere in the world.
- if exchange rates quoted in different markets
were not essentially the same, there would be an
opportunity for arbitrage - the process of buying a
currency low and selling it high.
3. Most transactions involve U.S. dollars on one side.
- the U.S. dollar is a vehicle currency.
Theories of Exchange Rate Determination
What factors are important to future exchange rates?
1. Three factors that have an important impact on future
exchange rate movements are:
b. A country’s interest rate
c. Market psychology
How are prices related to exchange rate movements?
1. To understand how prices and exchange rates are
linked, we need to understand:
a. the law of one price
b. the theory of purchasing power parity
How do interest rates affect exchange rates?
1. Fisher Effect
- states that a country’s nominal interest rate (i)
is the sum of the required real rate of interest (r ) and the
expected rate of inflation over the period for which the
funds are to be lent (l). (i = r + l)
2. International Fisher Effect
- suggests that for any two countries, the spot
exchange rate should change in an equal amount but in
the opposite direction to the difference in nominal
interest rates between the two countries.
How are exchange rates influences by investor
psychology?
1. Bandwagon Effect
- occurs when expectations on the part of traders
turn into self-fulfilling prophecies, and traders join the
bandwagon and move exchange rates based on group
expectations.
- governmental intervention can prevent the
bandwagon from starting but is not always effective.
Exchange Rate Forecasting
Should companies invest in exchange rate forecasting
services to help with decision-making?
1. Efficient Market School
- argues that forward exchange rates are the best
predictors of future spot exchange rates.
- investing in forecasting services would be a
waste of money.
2. Inefficient Market School
- argues that companies should invest in
forecasting services.
- forward rates are not the best predictor of
future spot rates.
How should exchange rate forecasts be prepared?
There are two approaches to exchange rate forecasting:
1. Fundamental analysis 2. Technical analysis
Currency Convertibility
A currency is:
1. Freely Convertible
- when both residents and non-residents can
purchase unlimited amounts of foreign currency with the
domestic currency.
2. Externally Convertible
- when only non-residents can convert their
holdings of domestic currency into a foreign currency.
3. Nonconvertible
- when both residents and non-residents are
prohibited from converting their holdings of domestic
currency into a foreign currency.
Implications for Managers
What does the foreign exchange market mean for
international firms?
1. Firms must understand the influence of exchange
rates on the profitability of trade and investment deals.
2. This exchange rate risk can be divided into:
a. Transaction exposure
b. Translation exposure
c. Economic exposure
How can firms minimize translation and transaction
exposure?
1. Firms can
- buy forward
- use swaps
- lead and lag payables and receivables – paying
suppliers and collecting payment from customers early
or late depending on expected exchange rate
movements.
How can a firm reduce economic exposure?
1. To reduce economic exposure firms need to distribute
productive assets to various locations so the firm’s long-
term financial well-being is not severely affected by
changes in exchange rates.
2. This requires that the firm’s assets are not overly
concentrated in countries where likely rises in currency
values will lead to damaging increases in the foreign
prices of the goods and services they produce.
Are there other strategies to manage foreign exchange
risk?
1. To further manage foreign exchange risk, firms should:
- establish central control to protect resources
and ensure that each subunit adopts the correct mix of
tactics and strategies.
- distinguish between transaction, translation,
and economic exposure.
- attempt to forecast future exchange rates
- establish good reporting systems
- produce monthly foreign exchange exposure
reports.
INTERNATIONAL BUSINESS AND TRADE
Chapter 9 – The Strategy of International
Business
Strategy
- refers to the actions that managers take to
attain the goals of the firm.
▪ Firms need to pursue strategies that increase
profitability and profit growth.
Profitability
- the rate of return the firm makes on its invested
capital.
Profit Growth
- the percentage increase in net profits over
time.
To increase profitability and profit growth, firms can:
1. Add value
2. Lower costs
3. Sell more in existing markets
4. Expand internationally
How is value created?
- to increase profitability, firms need to create
more value.
- The firm’s value creation is the difference
between V (the price that the firm can charge for that
product given competitive pressures) and C (the costs of
producing that product).
- a firm has high profits when it creates more
value for its customers and does so at a lower cost.
▪ Profits can be increased by using:
1. Differentiation Strategy
- adding value to a product so that customers are
willing to pay more for it.
2. Low Cost Strategy
- lowering costs.
Why is Strategic Positioning important?
1. Michael Porter argues that firms need to choose either
differentiation or low cost, and then configure internal
operations to support the choice.
2. To maximize long run return on invested capital, firms
must:
a. Pick a viable position on the efficiency frontier.
b. Configure internal operations to support that
position.
c. Have the right organization structure in place to
execute the strategy.
How are a firm’s operations configured?
1. A firm’s operations are like a value chain composed of
a series of distinct value creation activities:
- production, marketing, materials management,
R&D, human resources, information systems, and the
firm infrastructure.
2. All of these activities must be managed effectively and
be consistent with firm strategy.
3. Value creation activities can be categorized as:
a. Primary Activities
i. R&D
ii. Production
iii. Marketing and Sales
iv. Customer service
b. Support Activities
i. Information Systems
ii. Logistics
iii. Human Resources
How can firms increase profits through International
Expansion?
1. International firms can:
a. Expand their Market
- sell in international markets.
b. Realize Location Economies
- disperse value creation activities to locations
where they can be performed most efficiently and
effectively.
c. Realize Greater Cost Economies from Experience
Effects.
- serve an expanded global market from a central
location.
d. Earn a Greater Return
- leverage skills developed in foreign operations
and transfer them elsewhere in the firm.
How can firms leverage their products and
competencies?
1. Firms can increase growth by selling goods or services
developed at home internationally.
2. The success of firms that expand internationally
depends on:
a. the goods or services sold
b. the firm’s core competencies
Core Competencies
- skills within the firm that competitors cannot
easily match or imitate.
- can exist in any value creation activity
- allow firms to reduce
- the costs of value creation and/or to create
perceived value so that premium pricing is possible.
Why are location economies important?
Location Economies
- economies that arise from performing a value
creation activity in the optimal location for that activity,
wherever in the world that might be.
- By achieving location economies, firms can:
i. lower the costs of value creation and
achieve a low cost position.
ii. differentiate their product offering
 - firms that take advantage of location economies
in different parts of the world, create a global web of
value creation activities.
- different stages of the value chain are dispersed
to locations where perceived value is maximized or
where the costs of value creation are minimized.
Experience Curve
- the systematic reductions in production costs
that occur over the life of a product.
- by moving down the experience curve, firms
reduce the cost of creating value.
- to get down the experience curve quickly,
firms can use a single plant to serve global markets.
Learning Effects
- cost savings that come from learning by
doing.
- when labor productivity increases:
i. individuals learn the most efficient ways to
perform particular tasks.
ii. managers learn how to manage the new
operation more efficiently.
Economies of Scale
- the reductions in unit cost achieved by
producing a large volume of a product.
Sources of economies of scale include:
1. Spreading fixed costs over a large volume.
2. Utilizing production facilities more intensively.
3. Increasing bargaining power with suppliers.
How can managers leverage subsidiary skills?
Managers should:
1. Recognize that valuable skills that could be applied
elsewhere in the firm can arise anywhere within the
firm’s global network – not just at the corporate center.
2. Establish an incentive system that encourages local
employees to acquire new skills.
3. Have a process for identifying when valuable new skills
have been created in a subsidiary.
4. Act as facilitators to help transfer skills within the firm.
What types of Competitive Pressures exist In the Global
Marketplace?
1. Firms that compete in the global marketplace face two
conflicting types of competitive pressures.
- the pressures limit the ability of firms to realize
location economies and experience effects, leverage
products, and transfer skills within the firm.
2. Dealing with both pressures is challenging.
Two Competitive Pressures:
1. Pressures for Cost Reductions
- force the firm to lower unit costs.
2. Pressures to be Locally Responsive
- require the firm to adapt its product to meet
local demands in each market.
- this strategy can raise costs.
When are pressures for Cost Reductions greatest?
Pressures for cost reductions are greatest:
1. In industries producing commodity type products that
fill universal needs (needs that exist when the tastes and
preferences of consumers in different nations are similar
if not identical) where price is the main competitive
weapon.
2. When major competitors are based in low-cost
locations.
3. Where there is persistent excess capacity.
4. Where consumers are powerful and face low switching
costs.
When are pressures for Local Responsiveness greatest?
Pressures for local responsiveness arise from:
1. Differences in consumer tastes and preferences.
- strong pressure emerges when consumer
tastes and preferences differ significantly between
countries.
2. Differences in traditional practices and infrastructure.
- strong pressure emerges when there are
significant differences in infrastructure and/or
traditional practices between countries.
3. Differences in distribution channels.
- need to be responsive to differences in
distribution channels between countries.
4. Host government demands.
- economic and political demands imposed by
host country governments may require local
responsiveness.
Which strategy should a firm choose?
There are four basic strategies to compete in
international markets:
- the appropriateness of each strategy depends on
the pressures for cost reduction and local responsiveness
in the industry.
- firms differentiate their product across
geographic markets to account for local differences and
foster a multidirectional flow of skills between different
subsidiaries in the firm’s global network of operations.
- this strategy makes sense when both cost
pressures and pressures for local responsiveness are
intense.
4. International
- take products first produced for the domestic
market and sell them internationally with only minimal
local customization.
- this strategy makes sense when there are low
cost pressures and low pressures for local
responsiveness.

How does strategy evolve?

1. Global Standardization
- increase profitability and profit growth by
reaping the cost reductions from economies of scale,
learning effects, and location economies.
- goal is to pursue a low-cost strategy on a global
scale.
- this strategy makes sense when there are
strong pressures for cost reductions and demands for
local responsiveness are minimal.
- an international strategy may not be viable in the
long term.
- to survive, firms may need to shift to a global
standardization strategy or a transnational strategy in
advance of competitors.
- localization may give a firm a competitive edge,
but if the firm is simultaneously facing aggressive
competitors, the company will also have to reduce its
cost structures.
- would require a shift toward a transnational
strategy.

2. Localization
- increase profitability by customizing goods or
services so that they match tastes and preferences in
different national markets.
- this strategy makes sense when there are
substantial differences across nations with regard to
consumer tastes and preferences and cost pressures are
not too intense.

3. Transnational
- tries to simultaneously achieve low costs
through location economies, economies of scale, and
learning effects.