International trade theories

Understanding international trade theories is fundamental for individuals, companies, and

nations to comprehend the workings of international trade and business. These theories shed
light on the international market, highlight the obstacles that hinder success for businesses,
and provide insights into how companies can establish their presence in the global market.

In the domestic business, it is crucial to consider the behaviour and motivation of buyers.
However, in international business or trade, it is more important to have a solid grasp of the
fundamental causes and nature of business. To achieve this, it is necessary to gain a clear
understanding of international trade theories. These are explained below:
I) Classical Theories:
The developers of classical theories follow a country-based approach which is mainly
concerned with the fact that preference should be given to raising the wealth of one’s own
nation. Major classical theories with regard to international trade are discussed below:

1.Mercantilism Theory
Emerged in – the 16th century
What this theory states: As per this theory, a country’s wealth was measured by the amount of
gold and silver it possessed, which was thought to be the basis of economic power.
Mercantilists believed that a country should increase its holdings of gold and silver by
promoting exports and discouraging imports.
To achieve this goal, they advocated for government intervention in trade through
protectionist policies, such as tariffs and quotas, and for the development of domestic
industries that could produce goods for export. The ultimate objective was to have a trade
surplus, where a country exports more than it imports.
2. Absolute Advantage Theory

Developed by – Adam Smith in the 18th century

What this theory states: A country should specialize in producing goods and services that it can
produce more efficiently than other countries. This specialization will lead to increased
efficiency and greater overall output, benefiting both the producing country and the global
economy as a whole.
The theory suggests that free trade should be promoted, as it allows countries to specialize
and trade with each other, leading to mutual gains.
Absolute Advantage theory is based on the idea that nations have different abilities in terms of
producing goods and services and that they can benefit from exchanging the goods and
services they produce most efficiently.
3. Comparative Advantage
Developed by – David Ricardo in the early 19th century
What this theory states: This theory argues that a country should specialize in producing goods
in which it has a comparative advantage, meaning it can produce the goods at a lower
opportunity cost than other countries. By specializing in this way, countries can increase
overall output and trade with each other for mutual benefit.
4. Heckersher Ohline Theory or Factor proportion theory
Developed by – Eli Heckscher in 1920
What this theory states: The Heckscher-Ohlin Theory, also known as the Factor Proportion
Theory, is an economic theory that suggests that countries will specialize in producing and
exporting goods that require abundant factors of production, such as labour or capital, and
import goods that require scarce factors of production.
The theory argues that free trade between countries leads to a more efficient global allocation
of resources, as each country specializes in producing goods that it can produce most
efficiently. The theory helps to explain why countries specialize in certain industries and how
trade can benefit both importing and exporting countries.
5. Leontief's paradox theory
Leontief's paradox in economics is that a country with a higher capital per worker has a lower
capital/labor ratio in exports than in imports.
This econometric finding was the result of Wassily W. Leontief's attempt to test the
Heckscher–Ohlin theory ("H–O theory") empirically. In 1953, Leontief found that the United
States—the most capital-abundant country in the world—exported commodities that were
more labor-intensive than capital-intensive, contrary to H–O theory .Leontief inferred from
this result that the U.S. should adapt its competitive policy to match its economic realities

II) Modern or firm Based Trade Theories:

These theories emerged during the period of World War II. these are created by professors of
business schools and by experts from multinational companies. The following are the modern
or firm-based theories:

1.Country Similarity Theory

Developed by – Steffan Linder in 1961

What this theory states: Country Similarity Theory is an economic theory that proposes that
countries tend to trade more with other countries that are similar to them in terms of culture,
language, geography, and economic development.
The theory suggests that countries with similarities are more likely to have similar demand
patterns and preferences for goods and services, and thus are more likely to have a
comparative advantage in producing goods that are in demand in their partner country.
The theory helps to explain why some countries have stronger trade relationships with certain
partners, and why trade patterns are often regionally concentrated. However, it has been
criticized for oversimplifying the complex factors that influence international trade patterns.
2. Product Life Cycle Theory
Developed by – Raymond Vernon in the 1960s
What this theory states: This theory argues that a product goes through three stages:
introduction, growth, and maturity. During the introduction stage, the product is produced in
the country where it was invented.
As the product grows, production shifts to countries with lower costs of production. Finally,
during the maturity stage, production shifts to countries where the product can be produced
most efficiently.
3.Global Strategic Rivalry Theory

Developed by – Paul Krugman and Kelvin Lancaster in the 1980s

What this theory states: The Global Strategic Rivalry Theory, also known as the New Trade
Theory, suggests that international trade patterns and competitiveness are influenced by
factors beyond differences in factor endowments.
This theory highlights the importance of economies of scale, technological innovation, and
government policies in shaping trade patterns. The Global Strategic Rivalry Theory emphasizes
the need for countries to invest in developing competitive industries and promoting
innovation to gain a strategic advantage in global trade.
4.Porter’s National Competitive Advantage Theory

Developed by – Michael Porter in the 1985s

What this theory states: Porter’s National Competitive Advantage Theory, also known as the
Diamond Model, proposes that the competitive advantage of an industry in a country depends
on four interrelated factors: factor endowments, demand conditions, related and supporting
industries, and firm strategy, structure, and rivalry.
This theory suggests that countries can gain a competitive advantage in specific industries by
developing and leveraging these factors. Porter’s theory highlights the importance of factors
beyond traditional economic factors, such as industry-specific skills and infrastructure, in
shaping the competitiveness of industries.

Foreign exchange market

The foreign exchange market (also known as forex, FX, or the currencies market) is an over-
the-counter (OTC) global marketplace that determines the exchange rate for currencies
around the world. Participants in these markets can buy, sell, exchange, and speculate on the
relative exchange rates of various currency pairs.
Foreign exchange markets are made up of banks, forex dealers, commercial companies,
central banks, investment management firms, hedge funds, retail forex dealers, and investors.
The foreign exchange market—also called forex, FX, or currency market—was one of the
original financial markets formed to bring structure to the burgeoning global economy. This
asset class makes up the largest financial market in the world in terms of the value of currency
units being traded. Aside from providing a venue for the buying, selling, exchanging, and
speculation of currencies, the forex market also enables currency conversion for international
trade settlements and investments.
Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is
relative to the value of the other. This determines how much of country A's currency country B
can buy, and vice versa. Establishing this relationship (price) for the global markets is the main
function of the foreign exchange market. This also greatly enhances liquidity in all other
financial markets, which is key to overall stability.
The value of a country's currency depends on whether it is a "free float" or "fixed float." Free-
floating currencies are those whose relative value is determined by free-market forces, such as
supply-demand relationships.
A fixed float is where a country's governing body sets its currency's relative value to other
currencies, often by pegging it to some standard. Free-floating currencies include the U.S.
dollar, Japanese yen, and British pound, while examples of fixed floating currencies include the
Panamanian Balboa and the Saudi Riyal.
One of the most unique features of the forex market is that it's made up of a global network of
financial centers that transact 24 hours a day, closing only on the weekends. As one major
forex hub closes, another hub in a different part of the world remains open for business. This
increases the liquidity available in currency markets, which adds to its appeal as the largest
asset class available to investors.
The most liquid trading pairs are, in descending order of liquidity:
• EUR/USD
• USD/JPY
• GBP/USD2
Currency quotes
In foreign exchange (forex), the quote currency, commonly known as the counter currency, is
the second currency in both a direct and indirect currency pair and is used to determine the
value of the base currency.
In a direct quote, the quote currency is the foreign currency, while in an indirect quote, the
quote currency is the domestic currency. The quote currency is listed after the base currency
in the pair when currency exchange rates are quoted. One can determine how much of the
quote currency they need to sell in order to purchase one unit of the first or base currency.

Calculation of forward rates using spot rates

Spot Rates
A spot interest rate gives you the price of a financial contract on the spot date. The spot date
is the day when the funds involved in a business transaction are transferred between the
parties involved. It could be two days after a trade, or even on the same day the deal is
completed. A spot rate of 5% is the agreed-upon market price of the transaction based on
current buyer and seller action.
Forward Rates
In theory, forward rates are prices of financial transactions that are expected to take place at
some future point.
A forward rate indicates the interest rate on a loan beginning at some time in the future,
whereas a spot rate is the interest rate on a loan beginning immediately. Thus, the forward
market rate is for future delivery after the usual settlement time in the cash market.
Theoretically, the forward rate should be equal to the spot rate, plus any earnings from the
security (and any finance charges). You can see this principle in equity forward contracts,
where the differences between forward and spot prices are based on dividends payable, less
interest payable during the period.
A spot rate is used by buyers and sellers looking to make an immediate purchase or sale, while
a forward rate is considered to be the market's expectations for future prices. It can serve as
an economic indicator of how the market expects the future to perform, while spot rates are
not indicators of market expectations. Instead, spot rates are the starting point to any financial
transaction.

Understanding Forward Premiums

Forward currency exchange rates are often different from the spot exchange rate for the
currency. If the forward exchange rate for a currency is more than the spot rate, a premium
exists for that currency. A discount happens when the forward exchange rate is less than the
spot rate.

Interest rate Parity

Interest rate parity (IRP) is an equation used to manage the relationship between currency
exchange and interest rates. It’s used by investors, playing a pivotal role in connecting spot
exchange rates, foreign exchange rates, and interest rates on the foreign exchange markets.

The fundamental concept behind the IRP is that the interest rate differential between two
countries will be equal to the differential between the spot exchange rate and the forward
exchange rate. When you invest in different currencies, the hedged returns should be the
same regardless of fluctuations in interest rates.
The forward exchange rate should equal the spot currency exchange rate multiplied by the
interest rate of the home country, then divided by the foreign currency interest rate.

Interest rate parity is also behind the no-arbitrage concept. In foreign exchange markets, this
refers to the purchase and sale of a single asset enabling a trader to benefit from price
differences. In other words, a forex trader can’t lock in the currency exchange rate from one
country at a lower price, simultaneously purchasing another currency with a higher interest
rate

PPP Principal
Purchasing power parity (PPP) is a popular macroeconomic analysis metric used to compare
economic productivity and standards of living between countries.
PPP involves an economic theory that compares different countries' currencies through a
"basket of goods" approach. That is, PPP is the exchange rate at which one nation's currency
would be converted into another to purchase the same and same amounts of a large group of
products.1
According to this concept, two currencies are in equilibrium—their currencies are at par—
when a basket of goods is priced the same in both countries, taking into account the exchange
rates.

International fisher effects

The International Fisher Effect (IFE) is an economic theory stating that the expected disparity
between the exchange rate of two currencies is approximately equal to the difference
between their countries' nominal interest rates.
• The International Fisher Effect (IFE) states that differences in nominal interest rates
between countries can be used to predict changes in exchange rates.
• According to the IFE, countries with higher nominal interest rates experience higher
rates of inflation, which will result in currency depreciation against other currencies.
• In practice, evidence for the IFE is mixed and in recent years direct estimation of
currency exchange movements from expected inflation is more common.
The Fisher effect describes the relationship between interest rates and the rate of inflation. It
proposes that the nominal interest rate in a country is equal to the real interest rate plus the
inflation rate, which means that the real interest rate is equal to the nominal rate of interest
minus the rate of inflation.
Therefore, any increase in the rate of inflation will result in a proportional increase in the
nominal interest rate, where the real interest rate is constant.
Formula:
(1 + Nominal Interest Rate) = (1+Real Interest Rate) (1+Inflation Rate)

Bretton Woods Agreement

The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at
the United Nations Monetary and Financial Conference held in Bretton Woods, New
Hampshire. Thus, the name “Bretton Woods Agreement.
Under the Bretton Woods System, gold was the basis for the U.S. dollar and other currencies
were pegged to the U.S. dollar’s value. The Bretton Woods System effectively came to an end
in the early 1970s when President Richard M. Nixon announced that the U.S. would no longer
exchange gold for U.S. currency.
Approximately 730 delegates representing 44 countries met in Bretton Woods in July 1944
with the principal goals of creating an efficient foreign exchange system, preventing
competitive devaluations of currencies, and promoting international economic growth. The
Bretton Woods Agreement and System were central to these goals. The Bretton Woods
Agreement also created two important organizations—the International Monetary Fund (IMF)
and the World Bank. While the Bretton Woods System was dissolved in the 1970s, both the
IMF and World Bank have remained strong pillars for the exchange of international currencies.
• The Bretton Woods Agreement and System created a collective international currency
exchange regime that lasted from the mid-1940s to the early 1970s.
• The Bretton Woods System required a currency peg to the U.S. dollar which was in turn
pegged to the price of gold.
• The Bretton Woods System collapsed in the 1970s but created a lasting influence on
international currency exchange and trade through its development of the IMF and
World Bank.
Exchange rate regime
An exchange rate regime is a way a monetary authority of a country or currency union
manages the currency about other currencies and the foreign exchange market. It is closely
related to monetary policy and the two are generally dependent on many of the same factors,
such as economic scale and openness, inflation rate, the elasticity of the labor market,
financial market development, and capital mobility.[1]
There are two major regime types:
• Floating (or flexible) exchange rate regime exist where exchange rates are determined
solely by market forces and often manipulated by open-market operations. Countries do
have the ability to influence their floating currency from activities such as buying/selling
currency reserves, changing interest rates, and through foreign trade agreements.
•
Fixed (or pegged) exchange rate regimes, exist when a country sets the value of its
home currency directly proportional to the value of another currency or commodity. For
years many currencies were fixed (or pegged) to gold. If the value of gold rose, the value
of the currency fixed to gold would also rise. Today, many currencies are fixed (pegged)
to floating currencies from major nations. Many countries have fixed their currency
value to the U.S. dollar, the euro, or the British pound.
There are also intermediate exchange rate regimes that combine elements of the other
regimes.

International Banking
International Banking is a process that involves banks dealing with money and credit between
different countries across the political boundaries. It is also known as Foreign/Offshore
Banking. In another words, International Banking involves banking activities that cross national
frontiers. It concerns the international movement of money and offering of financial services
through off shore branching, correspondents banking, representative offices, branches and
agencies, limited branches, subsidiary banking, acquisitions and mergers with other foreign
banks. All the basic tools and concepts of domestic bank management are relevant to
international banking. However, special problems or constraints arise in international banking
not normally experience when operating at home.

Universal banking
• Universal banking refers to a banking system that offers a wide range of banking and
financial services compared to traditional banking institutions.
• The participating banks in a universal banking system are not required to offer all the
banking services; rather, they are free to select and offer various services.
• Universal Banking has several functions, such as Commercial Banking and Investment
Banking, maintaining investors’ faith, optimum utilization of resources, etc.
• Commercial banks, known as universal banks, provide a staggering array of services all
under one roof. In contrast, a commercial bank offers necessary services, including
customer deposits, disbursing loans, locker facilities, demand draughts, credit cards, and
remittance services.
Some of the more notable universal banks include Deutsche Bank, HSBC, and ING Bank; within
the United States, Bank of America, Wells Fargo, and JPMorgan Chase qualify as universal
banks.
Global depository receipt
A global depositary receipt (GDR) is a negotiable financial instrument issued by a depositary
bank. It represents shares in a foreign company and trades on the local stock exchanges in
investors' countries. GDRs make it possible for a company (the issuer) to access investors in
capital markets beyond the borders of its own country.
GDRs are commonly used by issuers to raise capital from international investors through
private placement or public stock offerings.
A global depositary receipt is very similar to an American depositary receipt (ADR) except that
an ADR only lists shares of a foreign company in U.S. markets.
A global depositary receipt is a type of bank certificate that represents shares of stock in an
international company. The shares underlying the GDR remain on deposit with a depositary
bank or custodial institution.
While shares of an international company trade as domestic shares in the country where the
company is located, global investors located elsewhere can invest in those shares through
GDRs.
Using GDRs, companies can raise capital from investors in countries around the world. For
those investors, the GDRs will be denominated in their home country currencies. Since GDRs
are negotiable certificates, they trade in multiple markets and can provide arbitrage
opportunities to investors.
GDRs are generally referred to as European Depositary Receipts, or EDRs, when European
investors wish to trade locally the shares of companies located outside of Europe.

Global depository receipts procedure

Following is the process of issuing GDRs:

• Indian companies issue equity shares in Indian rupees to a domestic custodian bank
which transfers it to an overseas depository bank. The shareholders, board of directors,
financial institutions and regulatory authorities must approve the issuance of GDRs
before they are issued.
 • The domestic custodian bank physically holds the equity shares. In the company's books,
the depository bank is listed as the owner of the company's equity shares. Equity
shareholders’ voting rights are transferred to the depository bank.
• The domestic custodian bank acts as the agent of the overseas depository bank. It holds
the equity shares in its possession.
• The overseas depository bank provides GDRs in foreign currency. The bank converts the
GDRs into shares to trade them on the country's stock exchange. The country's investors
can sell and buy the shares just like any other security.

Brokers representing buyers manage the sale and purchase of GDRs. Usually, the brokers
belong to the home country and operate within the foreign market. The actual purchase of the
assets is multi-staged, involving a broker located within the market of the international
company, a broker in the investor's country, a custodian bank and a depositary bank
representing the buyer.

Brokers can also sell GDRs on behalf of an investor. An investor can sell them on the proper
exchanges or convert them into regular stock for the company. Additionally, they can be
cancelled and returned to the issuing company.

Indian deposiory receipt

An IDR is in Indian rupees and is created by a domestic depository (custodian of securities

registered with SEBI (Securities and Exchange Board of India). It is issued against the
underlying equity of the company to enable foreign companies to raise funds from the Indian
securities Markets. As foreign companies are not allowed to list on Indian equity markets, IDR
is a way to own shares of those companies. These IDRs could be listed on the Indian stock
exchanges. Through the IDRs, you could directly invest money into international companies.

These are foreign companies that have subsidiaries working in India. Since these offshoots are
not listed, the firms offer shares to Indian investors.
Eligible to issue IDR: The foreign issuing company shall have pre-issue paid-up capital and free
reserves of at least US$ 50 million and have a minimum average market capitalisation (during
the last three years) in its parent country of at least US$ 100 million. It should have a
continuous trading record or history on a stock exchange in its parent country for at least
three immediately preceding years. It should have a track record of distributable profits for at
least three out of immediately preceding five years. It should be listed in its home country and
not been prohibited from issuing securities by any regulatory body and has a good track record
concerning compliance with securities market regulations. The size of an IDR issue shall not be
less than Rs 50 crores.