International Economics

Question 1

What is International Economics?

Answer 1

• It’s the study of economic activity that occurs accross national boundaries.
• It may involve:
  
  • Trade
  • Investment
  • Operations
  • Etc.

Question 2

What are the major reasons for international economic activity?

Answer 2

1. Increase markets for sale of goods and services
2. Obtain commodities not otherwise available, or available only in limited supply
3. Obtain commodities at a lower cost than is available in home country.

Question 3

Define “Absolute Advantage”:

Answer 3

• The ability of a country, business, or individual to produce a good or service more efficiently than another entity.
  
  • More efficiently = With fewer “input” resources

Question 4

Define “Comparative Advantage”:

Answer 4

• The ability of one country, business, or individual to produce a good or provide a service with lower opportunity cost than another entity.
  
  • It derives from differences in availability of resources and technology among entities.

Question 5

Identify some reasons for comparative advantage between countries:

Answer 5

Differences in availabilty of economic resources, including:

1. Natural resources
2. Labor
3. Technology

Question 6

In comparative advantage, what must an entity do to maximize output?

Answer 6

1. Entities should specialize in the goods or services they produce at the least opportunity cost.
2. Entities should trade with other entities for goods or services for which they do not have a comparative advantage.

• This is why the concept of comparative advantage underlies the benefits of international economic activity.

Question 7

What’s the Principle of Comparative Advantage?

Answer 7

The total output of two or more entities will be greatest when each produces the goods or services for which it has the lowest opportunity cost and they engage in trade with each other.

Question 8

What are the four broad national attributes (factors) identified by Michael Porter as promoting or impeding the creation of competitive advantage?

Answer 8

1. Factor endowments - advantages in factors of production - land, labor, infraestructure, etc.
2. Demand conditions - nature of domestic demand for a good/service
3. Relating and Supporting Industries - extent to which supplier and related industries are internationally competitive
4. Firm Strategy, Structure, and Rivalry - how entities are created, organized, managed, and how they compete

Question 9

What are Porter’s four outcomes that give national advantage?

Answer 9

1. Availabilty of resources and skills
2. Information used to determine which opportunities to pursue with resources and skills
3. Goals of individuals within entities
4. Pressures on entities to innovate and invest

Question 10

From an international perpective, the U.S. economy is an open economy:

Answer 10

It is connected to the economies of many other nations through trade, investment, and other financial activities. These international economic relationships provide important benefits to, and create challenges for, not only the national economy, but also for entities engaged in international economic activities.

Question 11

What are some socio-political issues associated with international trade?

Answer 11

1. Domestic unemployment linked to use of foreign labor.
2. Loss of manufacturing capabilities
3. Reduction of industries essential to national defense
4. Lack of domestic protection for start-up industries

Question 12

Political responses to such concerns (socio-political issues) often result in protectionism in the form of:

Answer 12

1. Import quotas - which restrict the quantity of goods that can be imported;
2. Import tariffs - which tax imported goods and thereby increases their cost.

Such forms of protectionism benefit some parties while harming others:

Parties Benefited:

• Domestic producers: retain market and charge higher prices.
• Federal government: obtains revenues through tariffs

Parties Harmed:

• Domestic consumers: pay higher prices and may have less choice of goods.
• Foreign producers: Loss of market

*Such forms of protectionism are generally innapropriate because they are based on economic misconceptions or because there are more appropriate fiscal and monetary policy responses.

Question 13

What’s the currency exchange rate?

Answer 13

It’s the price of one unit of a country’s currency expressed in units of another country’s currency.

• Exchange rates are important in determining the level of imports and exports for a country.
  
  • The lower the cost of a foreign currency in terms of domestic currency, the cheaper the foreign goods and services on that currency.
    
    • $1.10 = 1 euro (Stronger $)
    • $1.25 = 1 euro (Weaker $)
    • At $1.10 = 1 euro, US dollar can buy more goods than at $1.25=1 euro
    • More imports of Euro-based goods
    • Less exports to Euro-based buyers
  • The lower cost of foreign currency in terms of domestic currency, the higher the cost of domestic goods and services to foreign buyers, resulting in lower exports.

Question 14

What’s the Balance of Trade?

Answer 14

It’s the difference between money value of imports and exports.

• Exports > Imports = Trade surplus
• Exports < Imports = Trade deficit

Balance of Trade = Element of a country’s Balance of Payments accounting with other countries.

Question 15

What’s “Dumping”?

Answer 15

Dumping is a form of international price discrimination by which the price charged for a product exported and sold in (imported into) a foreign country is less than the price of the identical product in the market of the exporting country.

• Under agreements administered with the World Trade Org (WTO), dumping is not illegal unless the country importing the good can demonstrate that the dumping threatens the financial viabilty of domestic producers of the good or significantly hinders the establishment of a domestic industry for the good.

Question 16

What is a country’s Balance of Payments account?

Identify and describe them.

Answer 16

It’s a summary accounting of all of a country’s transactions with other countries.

1. Current Account:
   
   • Net $ amounts earned from export of goods and services
   • Amounts spent on import of goods and services
   • Goverment grants to foreign entities
2. Capital Account:
   
   • Net $ amount of inflows from investments and loans by foreign entities
   • Amount of outflows from investments and loans U.S. entities made abroad
   • The resulting net balance
3. Financial Account:
   
   • Net $ amount of U.S. owned assets abroad and foreign-owned assets in the U.S.

Question 17

What are the Balance of Payments Outcomes?

Answer 17

• Surplus = sum of earnings and inflows exceed the sum of spending and outflows.
  
  • Results in increase of US reserves of foregn currency or decrease in foreign government holdings of US currency.
• Deficit = sum of spending and outflows exceeds sum of earnings and inflows.
  
  • There’s a greater demand for foreign currency in dollars. This increases its value relative to dollar; now takes more dollars to buy given amount of foreign currency.
  • Consequences of Deficit Balance of Payments
    
    • Exchange rate of dollar weakens in value relative to foreign currency = more dollars to buy a fixed amount foreign currency.
    • Imports decrease and exports increase causing import/export trend to reverse
    • Thus, free-floating exchange rates (free market rates) help maintain balance of payment equilibrium.

Question 18

What is currency?

Answer 18

As a store of value, currency is a commodity, the value of which can be measured by the rate of which one currency will exchange for another.

Question 19

What’s a currency exchange rate?

Answer 19

The exchange rate is the price of one unit of a country’s currency expressed in units of another country’s currency.

It may be expressed as:

1. Direct exchange rate: the domestic price of 1 unit of foreign currency: 1 euro = $1.10
2. Indirect exchange rate: the foreign price of 1 unit of domestic currency: $1.00= .909 euro ($1.00/$1.10)

Question 20

Major Ways Exchange Rates are Determined:

Answer 20

1. Fixed exchange rate regime = a target exchange rate is established w another currency. The Govt or Central Bank intervenes in currency market so that exchange rates continue to approximate target rate.
2. Pegged exchange rate regime = the value of a country’s currency is fixed against another currency, basket of currencies, or the value of an international commodity like gold.
   
   • They are more common in developing countries and communist countries because pegged rates provide stability to the country’s currency, which provides general confidence in the currency/
3. Floating exchange rate regime = the exchange rates for a country’s currency are set primarily by supply and demand for the domestic currency relative to other currencies as determined by the foreign currency exchange market.
   
   • The Govt or Central Bank may intervine when necessary to stabilize domestic currency or to combat inflation. It doesn’t establish the exchange rate.
   • Has been more efficient than other regimes in determining the long term value of a currency and maintaining equilibrium in market.
   • Most developed countries, including the US, follow this regime.

Question 21

What are the 5 major factors that affect Currency Demand (and minor factors)?

Answer 21

1. Political and economic environment = political stability and strong economy increases demand.
2. Relative interest rates = higher rates relative to comparable countries increases investment which increases demand.
3. Relative inflation rates = lower rates retain purchasing power which increases demand.
4. Level of public debt = higher level of debt increases the risk of inflation which deters investment and decreases currency demand
5. Current Account Balance = higher deficit (excess imports over exports and investment outflows over inflows) increases demand for foreign currency relative to domestic currency.

Other minor factors are:

1. Consumer preferences
2. Relative incomes
3. Currency speculation - attempts to make a profit on trading securities

Question 22

What affects the Supply of Currency?

Answer 22

• Supply of currency is determined by a country’s Central Bank.
• US Fed determines currency supply through monetary policy.
• Examples of Fed affecting exchange rates:
  
  • Supply side:
    
    • Buying dollars in open market using foreign currency reserves to reduce supply of dollars and thus increasing the value of dollar.
    • Selling dollars would increase supply of dollars and thus decreasing the value of the dollar.
  • Demand side:
    
    • Increase of interest rates to increase the demand for domestic investments and dollars needed to acquire those investments; thus increases the value of the dollar.
    • Decrease of interest rates to decrease demand for domestic investments and dollards needed to acquire those investments; thus decreasing the value of the dollar.

Question 23

Exchange Rates and Impact on Domestic Economy: (Currency Appreciation and Depreciation)

Answer 23

1. Currency Appreciation = the value of a currency increases (becomes stronger) relative to another currency.
   
   • It takes less domestic currency to buy foreign currency or goods sold in that currency:
     
     • $.90 = 1 euro
     • 1.10 euro = $1.00
   • Consequences of Currency Appreciation:
     
     • Foreign goods cheaper for domestic buyers
     • Encourages increased domestic efficiencies in order to compete.
     • Puts downward pressure on domestic inflation by keeping prices low.
     • Makes it difficult for domestic producers to compete in domestic and foreign market.
     • Foreign companies will have an advantage in US market because dollar will buy more foreign goods.
2. Currency Depreciation = the value of a currency decreases (becomes weaker) relative to another country.
   
   • It takes more domestic currency to buy foreign currency or goods sold in that currency.
     
     • $1.10 = 1 euro
     • .909 euro = $1.00
   • Consequences of Currency Depreciation:
     
     • Domestic goods will become cheaper relative to foreign goods, which increases exports.
     • Increased exports increases domestic employment.
     • Import goods become more expensive.
       
       • This drives up the cost foreign inputs - raw materials, components, etc., as well as consumer goods.

Question 24

True or False: If the currency of Country A appreciates relative to country B, it will take more units of Country A currency to buy a unit of Country B.

Answer 24

• False: It takes less units of Country A to buy units in Country B:
  
  • $.90 = 1 euro
  • $1.00 = 1.10 euro

Question 25

True or False: If the currency of Country A appreciates relative to currency of Country B, goods produced in Country A will be less costly to buyers in Country B:

Answer 25

**False:** Goods will be more expensive to buyers in Country B. * $.90 = 1 euro * 1.10 euro = $1.00 For buyers in Country B, country A goods will be more expensive because it's more euros they have to spend.

Question 26

A country's currency conversion value has recently changed from 1.5 to the US dollar to 1.7 to the US dollar (foreign currency has weakened and dollar has appreciated value). What can be said about the country?

Answer 26

**Its exports are less expensive for the United States.** * Since the dollar has appreciated value relative to foreign currency, the US dollar will buy more of that country's goods/services and the exports of that country are less expensive.

Question 27

Freely fluctuating exchange rates perform what function?

Answer 27

**They automatically correct a lack of equilibrium in the balance of payments.** * A lack of equilibrium in the balance of payment result when a country has imports greater or less than exports and investments outlows different than inflows. That imbalance causes the relative demand for the currency of each country to be different. * _Fluctuating exchange rates permit these changing demands to be realized, which enables a return to equilibrium._ * **For example**, with a US deficit in the balance of payments, the US demand for foreign currencies will exceed foreign currencies provided by foreign currency inflows. As a result, there will be an increase in demand for foreign currencies relative to the US dollar, and freely fluctuating exchange rates will enable the value of the dollar relative to other currencies (i.e., the exchange rate) to fall and help move the balance of payments back to equilibrium.

Question 28

What is the effect when a foreign competitor's currency becomes weaker compared to the US dollar?

Answer 28

**The foreign company will have an advantage in the US market.** * When a foreign currency becomes weaker compared to US dollar (or dollar becomes stronger compared to foreign currency), the US dollar will exchange for more units of the foreign currency. * As a result, dollars will buy more of the foreign competitor's goods/services, giving the foreign company an advantage in the US market.

Question 29

The statement expressed in the form of "1 euro = $1.20" expresses a:

Answer 29

**Direct exchange rate =** _Domestic price of 1 unit of foreign_ currency * Domestic price $1.20 of 1 unit of euro.

Question 30

Currency Exchange Risks at Entity Level:

Answer 30

* Entities than engage in international economic activity face currency exchange risks that entities engaged in only domestic activity do not face directly. * The effects of exchange rates can determine success or failure in international economic activity.

Question 31

What are the 3 types of Foreign Currency Exchange Risks faced by an entity?

Answer 31

1. Transaction Risk 2. Translation Risk 3. Economic Risk

Question 32

Define Transaction Risk:

Answer 32

**_Transaction Risk_** = The possible unfavorable impact of changes in currency exchange rates on **transactions that are denominated in a foreign currency**. * For example: * A domestic firm buys, sells, lends, borrows, or invests with the transaction denominated in foreign currency. * Such transactions result in receivables or payables that will be collected or paid using a foreign currency. * **The domestic entity will need to either:** * _Convert the foreign currency it recieved to dollars; or_ * _Convert the dollars to foreign currency to pay its liability._ * The **risk is a change in exchange rate** will: * _Decrease dollars collected from the receivable_ * _Increase dollars needed to satisfy the payable._

Question 33

Example of Transaction Risk:

Answer 33

**Transaction Risk Example:** * Assume a **US firm buys foreign goods on Oct 15** and agrees to **pay 500,000 foreing currency units (FCU) in 60 days.** * Exchange rates and dollare values are: * **10/15 - 1 FCU = $.72** x 500,000 FCU = $360,000 * **12/14 - 1 FCU = $.75** x 500,000 FCU = $375,000 * **_Foreign Exchange Loss: $15,000_**

Question 34

How can a firm **mitigate Transaction Risk?**

Answer 34

* **Matching**= Incur equal payables and receivables in the same currency for offsetting effects; a loss on one would be offset by a gain on the other * **Leading/Lagging Payments and Collections**= Paying obligations or collecting receivables earlier or later than otherwise to avoid exchange rate changes. * **Hedging=** Using offset or contra transactions so that a loss on one would be offset by a gain on the other.

Question 35

What is **"hedging"** and how can it be used?

Answer 35

**Hedging** is a _risk management strategy_ that involves using _offsetting or contra transactions_ so that a loss on one would be offset by a gain on the other. * ***Foreign Currency Hedging*** is the hedge of exposure to changes in the dollar value of assets, liabilities, or planned transactions to be settled (denominated) in a foreign currency.

Question 36

Hedging a Receivable Example:

Answer 36

* Assume an **A/R denominated in a foreign currency** * _Foreign currency will be received when the receivable is collected in the future._ * The dollar value of that foreign currency when collected may be less than now due to a change in exchange rates. * **_How can that risk be hedged?_** * A firm can enter into a **contract now (called Forward Contract)** to _sell the foreign currency when received at a price or rate set now._ * As a consecuence of the contract, the dollar value of the foreign currency to be received is **"fixed".** * The possible adverse effects of a change in the exchange rate between when the receivable occurs and when collected is mitigated.

Question 37

What are other Transaction Risks?

Answer 37

In addition to payables and receivables, there are other kinds of transactions at risks from changes in exchange rates including: * Forecasted foreign currency-denominated transactions * Unrecognized firm commitments

Question 38

Define "**Translation Risk"**:

Answer 38

**Translation Risk:** The possible unfavorable impact of _changes in currency exchange rates on Financial Statements of foreign operation that are coverted from a foreign currency to domestic currency._ * Translation occurs when a d**omestic entity has foreign operations which prepares its FS in a foreign currency.** * The foreign operation may be a branch, joint venture, partnership, equity investment, or subsidiary. * The translation of foreign FS may be needed to: * Apply equity method accounting * Combine with other entities * Consolidate with domestic parent * **_Foreign currency FS are translated (converted) using exchange rates._** * Foreign currency account balances are multiplied by an exchange rate to get the dollar amount. * Some accounts are translated using the **current (spot) exchange rate; that is rate at B/S date.** * Current exchange rates change continuously; therefore, dollar values change continuously. * **Risk** = Exchange rate changes such that: * Dollar value of assets decreases * Dollar value of liabilties increases

Question 39

Example of Translation Risk:

Answer 39

Example: * Foreign B/S reports Cash = 100,000 Euros * **Exchange rate: $1.25 per 1 Euro** * **Dollar value**: 100,000 E x $1.25 = **$125,000** * Assume exchange rate changes: * **Exchange rate: $1.10 pero 1 Euro** * **Dollar value**: 100,000 E x $1.10 = **$110,000** * **A change in exchange rate caused dollar value to be _$15,000 less_ than before rate changed.**

Question 40

How can a firm **mitigate Translation Risk?**

Answer 40

* _Reduce the amount of assets and liabilities_ coverted using a current (spot) exchange rate. * _Create offsetting assets or liabilties_ so that a gain on one is offset by a loss on another * _Borrow in the foreign currency in an amount approximating the net asset exposure_ so that a gain or loss on translation is offset by a loss or gain on the borrowing.

Question 41

Define "**Economic Risk**":

Answer 41

**_Economic Risk_:** The possibility that changes in exchange rates will **alter value of future revenues and costs.** * Changes in exchange rates may: * Make **future foreign revenues** covert to fewer dollars, or * Foreign expenses convert to more dollars * Such changes may make: * Future sales or purchases in foreign currency not be economically feasible, adversely affecting operations

Question 42

How can a firm **mitigate Economic Risk?**

Answer 42

* Distribute productive assets in different countries with different currencies. * Shift sources of revenues and expenses to different locations with different currencies.

Question 43

**Foreign Currency Hedging Instruments:** When are currencies hedged and what are the intruments used?

Answer 43

* **Foreign currency hedging is accomplished primarily through forward contracts:** * A **_foreign currency forward exchange contract_** is a contract to buy or sell a specified amount of foreign currency at a specified date. * Exchange contracts are legal obligations to buy or sell. * A **_foreign currency option contract_** is a contract that gives the right- the option- to buy or sell a specified amount of foreign currency for a specified time at a specified rate. * _Exercise of this contract is at the discretion of the option holder (buyer)_ * _If the exchange rate changes adversely, the holder will exercise the contract_ * _If the exchange rate does not change adversely, the holder will not exercise the contract._

Question 44

Distinguish between a foreign currency exchange contract and a foreign currency option contract.

Answer 44

* Under a **_foreign currency exchange contract,_** the obligation to buy or sell a foreign currency is **firm**; the **exchange must occur.** * Under a f**_oreign currency option contract_**, the party holding the option has the **right (option) to buy (call) or sell (put),** but does not have to exercise that option; t**he exchange will occur according to decision made by option holder.**

Question 45

A put is an option that gives its owner the right to do what?

Answer 45

**_Sell_ a specific security at fixed conditions of price and time.** **A put option** = is a contract that gives the owner the right, but not obligation to sell the specified amount at specific price and time,

Question 46

Example Exchange Rate Risk: Assume a U.S. company purchases shares of a French company for 1,000,000 euros on March 1, 2003, when the exchange rate was 1 E = $1.10. The investment is classified as available-for-sale by the U.S. company. After holding the shares for eight months, it sold the entire investment in the foreign market for 1,200,000 euros when the exchange rate was 1 E = $1.23. What dollar amount of total investment gain or loss would the U.S. company recognize?

Answer 46

* Investment cost= 1,000,000E x $1.10= $1,100,000 * Investment proceeds= 1,200,000Ex$1.23 = $1,476,000 * Total Gain on investment = $376,000

Question 47

What is "**Transfer Price**"?

Answer 47

**_Transfer price:_** Amount (price) at which goods and services are transferred between affiliated countries. ## Footnote * When the affiliated entities are located in different countries, the transfer price determines for the affiliated entity in each country: * Profit/loss, and therefore, * Taxes owed * _By manipulating transfer prices, **firms can manipulate taxes, and therefore, profits.**_ * In addition, _transfer prices are likely to have implications for performance evaluation and related motivational issues._

Question 48

Transfer Pricing Guidance in the U.S.:

Answer 48

* In the US, appropriate allocation of income between entities under common control is provided in IRS code. * That guidance provides that income should be allocated based on the functions performed and the risks assumed by each of the entities involved in arm's-length transactions.

Question 49

What are the **factors that affect transfer pricing**?

Answer 49

* There are 2 broad factors that influence the determination of international transfer prices: 1. Management's objectives in setting prices 2. Legal requirements governing transfer prices between countries * Management's objectived can be grouped into 2 major categories: 1. To maintain control and evaluate performance 2. To allocate and minimize cost * Minimizing costs focuses on total worldwide income taxes, but the minimizing of other costs may be an objective, including: 1. **Withholding of taxes,** that may apply to the transfer of cash as dividends, interest or royalties 2. **Import dutie**s, which are applied to goods based on transfer prices 3. **Profit repatriation restrictions**, which limit the amount of profits that can be transferred out of a country.

Question 50

Identify and describe the **three major bases for setting transfer prices:**

Answer 50

1. **Cost:** The transfer price is a function of the cost of the selling unit. 2. **Market Price:** The transfer price is based on the price of the good or service in the market (if available). 3. **Negotiated Price**: The transfer price is based on a negotiated agreement between buying and selling affiliates.

Question 51

What significant outcomes does the setting of transfer prices impact?

Answer 51

1. Profit recognized by separate units 2. Allocation of taxes between units 3. Measures of separate unit performance.

Question 52

Globalco, a U.S. parent, has subsidiaries in Germany (Gerco) and in England (Engco). Gerco produces products that are sent to Engco for final assembly and packaging. Engo then sends the goods to Globalco for retail sales in the U.S. The effective income tax rates faced by each of the companies is: * Globalco 22% * Engco 18% * Gerco 20% If the **objective of transfer prices is to minimize income taxes**, which of the following policies, within legally acceptable ranges, should Globalco adopt with respect to the transfer prices?

Answer 52

1. Gerco- produces. Income tax rate 20% 2. Engco- final assembly. Income tax rate 18% 3. Globalco- retail sales. Income tax rate 22% If the objective of transfer prices is to minimize income taxes, Globalco should: * **Minimize transfer price from Gerco to Engco and maximize transfer price from Engco to Globalco.** * **​**Since Engco has lowest tax rate, _the lowest income tax would be achieved by highest income reported by Engco._ * _That would be achieved if Engco **has lowest cost (minimum transfer price from Gerco)** and **highest sales price (maximum transfer price to Globalco**)._ * **It will only be taxed in Gerco and Engco** = minimum transfer price from Gerco to Engco (lowest cost) and maximum transfer price from Engco to Globalco (highest sales price). * See example on study text to understand better.

Question 53

Which of the following statements regarding international transfer pricing is/are correct? ## Footnote **I. Firms with operations in multiple nations can manipulate earnings through transfer pricing.** **II. The transfer price preferred by a foreign subsidiary manager may be different than the transfer price that maximizes consolidated profits.**

Answer 53

**Both I and II are correct.** ## Footnote * _Firms can manipulate earnings by using transfer pricing that results in a greater amount of profit attributed to a country with a lower tax rate and lesser profit attributed to a country with a higher tax rate._ As a consequence, tax expense would be reduced and income increased for the consolidated entity. * In addition, because unit profits are often used to evaluate performance, _subsidiary managers will prefer a transfer price that maximizes their unit profits, whether or not it maximizes consolidated profits._

Question 54

Define **"Globalization**":

Answer 54

The movement toward a more integrated and interdependent world economy, evidenced by the increased mobility throughout the world of: * Goods * Services * Labor * Technology * Capital

Question 55

What are the **factors** that have contributed to the **emergence of global economic activity?**

Answer 55

* **Advent of Global Institutions** (World Bank, International Monetary Fund, Multinational corporations, etc.) * **Reduction in trade and investment barriers** * **Technological advances**

Question 56

What is the **primary purpose of the World Bank?**

Answer 56

* **_World Bank:_** * With the o_bjective of promoting general economic development,_ (**including lending to developing countries**) primarily for: * Infraestructure * Agriculture * Education; and * Similar development needs

Question 57

What is the main objective of **The International Monetary Fund (IMF)**?

Answer 57

* **_IMF:_** * With the _objective of maintaining order in the international monetary system, largely by providing funds to economies in financial crises_, including: 1. **Currency crisis** = when speculation in the exchange value of a currency causes a dramatic depression in its value; 2. **Banking crisis** = when a loss in the banking system of a country leads to a "run on banks" (dramatic levels of withdrawals from a country's banks); 3. **Financial debt crisis** = when a country cannot meet its foreign debt obligations

Question 58

**Reduction in Trade and Investment Barriers: GATT and FDI**

Answer 58

* Reduction in worldwide trade barriers originated in 1947 with the initial **_General Agreement on Tariffs and Trade (GATT)_** * **​**Original GATT and subsequent variations are multilateral agreements for the purpose of: * Liberalize and encourage trade by _eliminating tariffs, subsidies to export industries, import quotas, and other barriers_ * _Harmonizing intellectual property laws, and reducing transportation and other costs_ of international business as a result of group undertakings. * The World Trade Organiztion (WTO) was subsequently established (1995) to encompass GATT and related international trade bodies. * The WTO also serves to "police" the international trading system. * Concurrent with reductions in trade barriers, many countries have **removed restrictions on investment in the country by foreign investors.** * Such investments are called **_"Foreign Direct Investments"._** * **_Foreign Direct Investment (FDI);_** is a direct investment by an entity _in facilities to manufacture and/or market goods and services in a foreign country._ * It involves investment in **non-monetary assets** (PPE)

Question 59

**Technological Advances In Globalization**:

Answer 59

* Final major reason for globalization has been technological advances. * _Significant tech advances_ have occured in: * **Communication and info processing**: the ability to transmit and process large quantities of voice and data at low costs * Internet and WWW * **Transportation advances:** have made the movement of people and products faster and cheaper, including: * Large aircraft * Cargo ships * Containerization

Question 60

**Challenges of Globalization:**

Answer 60

* **Globalization involves new challenges for an entity, challenges not faced by in a strictly domestic operations.** * _Addressing the challenges begins by understanding the broad macro-environment of a country, including its political, economic, and legal characteristics, and assessing the risk inherent in each:_ * **Political system:** Concerned with the system of government in a nation and the extent to which the system tends to be democratic or totalitarian. * Political risk: the possibility that political forces will cause significant adverse change in a country's business environment that will have negative affect on profits and other entity goals. * **Economic system**: Concerned with the extent to which the government intervenes in economic activities, and ranges from a market (free-enterprise) economy to a command economy, in which the government plays a predominant role. * Economic Risk: the possibility that management of an economy will cause dramatic adverse changes in a country's business environment, including such factors as inflation and adverse currency exchange rates. * **Legal system:** Concerned with the formal rules (laws) that specify behavior and the processes by which enforcement is carried out, especially: * Property rights * Contract laws * Intellectual property laws * Product and safety laws

Question 61

Define "**Globalization of Trade**":

Answer 61

**_Globalization of trade:_** The exhange of goods and services between and among countries. * **Exports** - goods and services sold to a buyer in a foreign country. * **Imports** - goods and services acquired from a seller in a foreign country.

Question 62

Identify the **factors that have facilitated or enabled an increase in global trade (or reasons for international trade growth):**

Answer 62

1. _Reductions in trade barriers_ 2. _Increased economic integration between nations_ 3. _Regional trade agreements (NAFTA, EEU, etc.)_ 4. _Development in communications (internet)_ 5. _Development of financial sector that supports inter-nation trade._

Question 63

**Global Trade Growth Facts:**

Answer 63

**Between 1950-2000:** * World economic output grew 6 fold * Global trade grew 17 fold **Between 2000-2008:** * World exports grew at average annual rate of 5% **In 2009:** * World exports declined by 12% (world economic recession) **In 2010 and 2011:** * World exports grew by 14% and 5% respectively.

Question 64

**U.S. Trade Growth Facts:**

Answer 64

**Between 1994 and 2012:** * US imports grew from abount %60B/month to about $235B/month. * US exports grew from about $50B/month to about $175B/month. * See graph:

Question 65

**U.S. Imports and Exports Facts:**

Answer 65

**US imports and exports as a portion of GDP have increased significantly since 1960.** * **Imports:** * In 1960, imports were 4% of GDP * In 2011, imports were 18% of GDP * **Exports:** * In 1960, exports accounted for 5% of GDP * in 2008, exports accounted for 14% of GDP

Question 66

**Largest Export/Impot Countries:**

Answer 66

**_List of Top 5 Countries by Exports - 2011 (In US dollars, add 000,000):_** 1. **China = $1,904,000** 2. Germany = $1,547,000 3. United States = $1,497,000 4. Japan = $787,000 5. France = $589,000 **_List of Top 5 Countries by Imports - 2011 (In US dollars, add 000,000):_** 1. **United States = $2,314,000** 2. China = $1,743,468 3. Germany = $1,339,000 4. Japan = $794,700 5. France = $684,000

Question 67

**U.S. Imports/Exports Composition:**

Answer 67

**_Percentage of Total_** **_End-Use Category Exports Imports_** Capital Goods/Equipment 24% 19% Industrial/ Natural Resources 24% 29% Consumer/Manufacture 8% 20% Automotive 6% 10% Agriculture/Food 6% 4% Other Goods 3% 2% Services _29% 16%_ **TOTALS** 100% 100%

Question 68

**Describe changes in US international trade over the past 50 years.**

Answer 68

* _Both imports and exports have grown dramatically over the past 50 years._ * The US is _by far the world's largest importer_ and one of the top 3 exports. * Imports and exports each account for about 15% of purchases and output, respectively * _The US exports only more agricultural products and services than it imports._

Question 69

**Globalization of Trade "Take Aways":**

Answer 69

* International trade has grown dramatically over recent years. * US trade also has grown dramatically over recent years, especially since the 1990s. * US imports have grown much more than exports. * US is world's largest import country * China has experienced greatest export growth. * China is world's largest export country

Question 70

Identify special costs associated with international trade that often are critical in determining the viability of such trade or, **Factors affecting costs of International Trade:**

Answer 70

1. **Transaction costs** = including costs of using letters of credit and costs of mitigating currency exchange risk. 2. **Transportation costs** = the extra costs of shipping goods long distances and/or using more costly transportation methods. 3. **Tariff and other compliance costs** = including the direct costs of tariffs and complying with other requirements. 4. **Time costs** = the costs associated with the extra time due to distance and other requirements.

Question 71

The long-term trend in the dollar value of US exports and imports reflects:

Answer 71

**_Exports Imports_** Increasing Increasing \*Long-term value for dollars of both imports and exports has been to increase (in dollar value)

Question 72

Define "**Globalization of Production**":

Answer 72

**_Globalization of Production:_** Sourcing or producing goods and services from around the world. *Sourcing=* buying of components of a production from an outside supplier, often located abroad. _The sourcing of goods and services may be accomplished in two general ways:_ 1. **Outsourcing** 2. **Foreign Direct Investment**

Question 73

What is "**Outsourcing**"?

Answer 73

**_Outsourcing_**= Acquiring a good or service from a separate or external provider under contractual terms. * ***International outsourcing***= provider is in a foreign country. * Goods obtained may be: * _Raw materials_ * _Intermediate goods_ * _Final goods_ * _Services (call centers, data entry, programming, etc.)_

Question 74

What are the **reasons for outsourcing?**

Answer 74

**_Reasons for outsourcing include:_** 1. Cost savings 2. Improved quality 3. Reduced delivery time 4. Enable entity to focus on core business 5. Scalability- abilty of something, esp a computer system, to adapt to increased demands. 6. Access to knowledge, talent, and best practices

Question 75

While **outsourcing** can provide significant benefits, it also presents **risks**, including:

Answer 75

1. **Quality risk**: goods/services do not meet buyer's standards. 2. **Security risk**: foreign provider missappropriates intellectual property, trade processes, data, etc. 3. **Export/Import risk:** trade barriers prevent transfer of goods/services. 4. **Currency exchange risk**: Exchange rates change unfavorably. 5. **Legal risk:** home country or foreign country laws are violated.

Question 76

When **outsourcing on a foreign country**, what are the **steps to be taken to minimize associated risks?**

Answer 76

1. *The use of due process in selection of providers*; determine the trustworthiness, competence, and past history of prospective suppliers. 2. *Use a qualified lawyer in the foreign country* for all foreign legal undertakings. 3. *Determing the legal and regulatory requirements for exports/imports in both countries* before entering into a countract with foreign supplier 4. *Execute a thorough contract with the supplier selected that includes an _arbitration clause_* - this provides a predetermined mechanism for resolving differences between buyer and supplier. 5. *Minimize currency exchange rate risk by negotiating payment in home country currency* o, lacking that, enter into hedging agreements. 6. *Be knowledgeable of and have strict policies concerning relevant legal requirements* in both home and foreign country.

Question 77

What is "**Foreign Direct Investment**"?

Answer 77

**_Foreign Direct Investment:_** Establishing owned or controlled facilities in a foreign location to produce goods or services. * Entity acquires property, plant, and equipment, and other assets in foreign country to carry out production or service functions. * Locate facilities based on a country's advantages - cost, quantity and quality of factors of production/service, etc. * Raw materials * Skilled labor

Question 78

What are the **objectives of Foreign Direct Investment?**

Answer 78

1. _Lower cost structure for goods and services_ 2. _Improve quality of goods or services_ 3. _Expand markets_ 4. _Increase growth potential_

Question 79

What are "Capital Markets"?

Answer 79

**_Capital Markets:_** Markets in which financial securities are traded. *They bring together providers of capital (investors) and users of capital (borrowers).* * Capital Market examples: * Stock markets * Bond markets * Money markets * Commodities markets

Question 80

**Domestic Capital Markets:**

Answer 80

**_Domestic Capital Markets:_** Historically, only domestic capital markets served as intermediary between providers and users of capital. *The use of strictly domestic capital markets has its **limitations:*** 1. Limited by size and wealth of domestic residents 2. Limited supply of domestic capital increases cost of capital 3. Providers are limited in the number of investment opportunities available

Question 81

**Globalization of Capital Markets: (Eurodollar market and Eurobond market)**

Answer 81

*Globalization permits interaction between providers and users world-wide.* **_Global Capital Market:_** Interconnected set of financial institutions and national markets that permit the trading of securities and other financial assets between and among investors and borrowers world-wide. * While *many institutions make up the global capital market*, there are _two formal major international financial markets:_ 1. **_Eurodollar Market_** (Euromarket): provides _short and intermediate-term loans_ world-wide **denominated in US dollars.** 2. **_Eurobond Market_** (Eurobonds): provide _long-term loans_ outside borrower's home country. Offered in major currencies. Avoids most gov't regulation.

Question 82

**Growth in Global Capital Markets:**

Answer 82

* Between 1990 and 2006: * **Cross border loans** increased from $3,600 billion to $17,875 billion (+500% increase) * **International equity offerings** increased from $18 billion to $377 billion (=$2,100% increase) * But starting in 2007, the world-wide recession caused cross-border financial flows to decline significantly. * Between 2007 and 2009, Bank for International Settlement reported: * **International bonds/notes increased** 15% * **International equity issues increased** 47% * **_Major reasons for global economic growth:_** * Government deregulations * Advances in communication and data processing

Question 83

What are the **Global Capital benefits**?

Answer 83

**_Benefits of Global Financial Markets:_** * For **_investors:_** * ***Greater range of investment opportunities*** * Chance for greater returns * Diversification of investments * For **_capital users (borrowers):_** * ***Greater funds availabilty*** * More sources of capital * Chance for lower costs of capital

Question 84

What are the **Risks of Global Financial Markets**?

Answer 84

Participation in capital markets incur the **_currency exchange risks_** that a change in exchange rates will: * Reduce domestic currency value of returns on foreign investments * Example: If during the period of a _foreign investment, the dollar strengthens against foreing currency, the investment will decline in domestic currency value,_ even if there is no change in value in the foreign exchange market. * Increase domestic currency cost of borrowing in foreign currency * Example: _If during period of foreign borrowing, the dollar weakens against foreign currency, the dollars required to service the foreign denominated debt will increase_, even though the interest rate in foreign currency remains unchanged. **_Risks can be mitigated by Hedging_**: * Forward/futures exchange contracts * Forward option contracts * Currency swap contracts.

Question 85

Question: In which circumstance, as the dollar changes against the foreign currency, would an **investment in a foreign currency result in fewer dollars** and a **borrowing in a foreign currency cost more dollars?**

Answer 85

**Investment in Foreign Currency = _Dollar Strengthens_** **Borrowing in Foreign Currency = _Dollar Weakens_** * If the _dollar strengthens against foreign currency_, an investment in that currency would result in fewer dollars. * If the _dollar weakens against a foreign currency,_ borrowing in that currency would cost more dollars as more dollars would be required to service and repay the debt.

Question 86

**Globalization and Power Shifts:**

Answer 86

**Growth of globalization has resulted in shifts in the economic importance among nations.** Shifts in importance have occured in: * _Output_ * _Trade_ * _Services_ * _Foreign Direct Investment_ * _Home country of multinational entities_

Question 87

**Globalization and Power Shifts - _OUTPUT (shifts over past 50 years):_**

Answer 87

* While the **world-wide output has more than tripled** over the last 50 years, the growth has not been uniform among countries/regions. * The **_most dramatic changes_** have been in: * The **decline of European share of output** - from about 36% to about 27%. * The **Asian share has increased** from about 15% to about 25%. * The share of output held by: US, Latin America, and Afica/Middle East has remained fairly constant. **_In the US:_** * Mid 1960's: 40% of world output * 1969 = 30% * 1969-2007: 25-35% * Since 2007: less than 25% * **2012: about 22%** * **2013-Forward: projected to continue to decline**

Question 88

**Globalization and Power Shifts - _TRADE (exports) : (shifts over past 50 yrs)_**

Answer 88

* ***The total level of world-wide trade has grown dramatically in past 50 yrs.*** * During that time the **_four largest export countries_** have been: * _China_ * _Germany_ * _US_ * _Japan_ * The s_hare of world-wide exports attributable (in total)_ to the 4 countries has remained contant, _around 30%._ * **Dramatic changes** have been: * **US has lost share from 18% to 8%** * **Japan has increased share from 3% to 5% and China has increased from 2% to about 9%.** * Germany has maintained about 9% share.

Question 89

**Globalization and Power Shifts - SERVICES:**

Answer 89

**_Two major reasons fro movement of services world-wide:_** 1. **Internet and global communications:** enables entities to relocate value-adding services to low-cost locations. * Call centers * Help Desks * Programming 2. **Relocation of services necessary to support foreign trade and production.**

Question 90

**Globalization and Power Shifts - FOREIGN DIRECT INVESTMENT (FDI):**

Answer 90

* The US share of word-wide accumulated FDI: * 1980= 40% * 2005= 20% * _In 2010, the US was one of the 3 largest investing countries and one of the 3 largest FDI receiving countries._ * Developing countries share a world-wide accumulated FDI : * 1980= 5% * 2005= 15%

Question 91

**Globalization and Power Shifts: MULTINATIONAL ENTITIES HOME COUNTRY:**

Answer 91

* US as home country for multinational entities: * **1973 - 50%** of largest 260 multinationals * **2005 - 30% o**f largest 100 multinationals * **2009 - 28%** of largest 500 multinationals

Question 92

What's the **_US_ share of world-wide GDP** (output) and share of **world-wide exports?**

Answer 92

* The **US share of world-wide output is approximately= 25%** * US exports are about **10% of world-wide exports.**

Question 93

Becoming Global: What are the primary ways an entity may engage in international business activity?

Answer 93

The alternative ways of engaging in international business activity include: 1. **Importing/Exporting** 2. **Foreign licensing** 3. **Foreign franchising** 4. **Forming a foreign joint venture** 5. **Creating or acquiring a foreign subsidiary**

Question 94

**Becoming Global: _Importing/Exporting:_**

Answer 94

**_Importing/Exporting:_** *Most basic form of international business.* ## Footnote **_Advantages of Exporting:_** * Increase domestic sales and output - achieve economies of scale domestically * Avoids cost of establishing foreign production capability * Provides experiences in international business at low risk. **_Advantages of Importing:_** * Obtaining goods not otherwise available * Obtaining goods at lower cost * Obtaining goods of better quality than similar goods produced in home country. **_Exporting/Importing Disadvantages:_** * _Possible high cost of transportation_ * Especially for *_**low value-to-weight ratio goods** (i.e., heavy relative to value)_* * _Existence or possibility of trade barriers_ * Quotas * Tariffs

Question 95

**Becoming Global: _Foreign Licensing_**

Answer 95

**_Foreign Licensing:_** Granting a foreign entity the right to use an asset: ## Footnote * Patent * Trademark * Formula * Etc. Licensee makes royalty payments to the licensor. **_Advantages of Foreign Licensing:_** * Increases revenue through royalties * Avoids trade barrier concerns * Avoids costs ans risks of opening a foreign operation **_Disadvantages of Foreign Licensing:_** * Licensee may misuse patents, technology processes, and other propietary information. * Licensor **may not** be able to control licensee sufficiently to assure standards are met * Licensee may not have management or technical capabilities to fully realize benefits of the license.

Question 96

**Becoming Global: _Foreign Franchising_**

Answer 96

**_Foreign Franchising:_** Special form of licensing in which franchisor typically mandates strict operating procedures. ## Footnote * Used primarily in foreign retail and service markets * Restaurants * Hotels * Franchisor frequently provides on-going assistance. **_Advantages of Foreign Franchising:_** * Provide increased revenues from royalties * Avoids costs and risks of opening foreign facilities **_Disadvantages of Foreign Franchising:_** * Franchisee may misuse proprietary information * Franchisee quality controls may not meet franchisor standards

Question 97

**Becoming Global: _Foreign Joint Venture_**

Answer 97

**_Foreign Joint Venture:_** An entity established in a foreign location and jointly owned by 2 or more otherwise unrelated entities. ## Footnote * One is typically located in the foreign country * May be used for various kinds of undertakings (Undertakings= a guarantee, promise, or stipulation that creates an obligation) **_Advantages of Foreign Joint Ventures:_** * Host country co-owner has knowledge of local environment. * Costs and risks of undertakings are shared with one or more venture partners. * Foreign local resistance from gov't, labor and other businesses may be less with a local stakeholder. **_Disadvantages of Foreign Joint Venture:_** * Foreign co-owner may misuse partner's patents, technology, proprietary info, etc. * Home country co-owner does not have absolute control. * Shared ownership can lead to differences in goals, objectives, strategy, etc.

Question 98

**Becoming Global: _Foreign Subsidiary_**

Answer 98

**_Foreign Subsidiary:_** Entity _acquires_ **or** _establishes a foreign subsidiary_ - a controlled, but legally separate entity. ## Footnote _**Advantages of *Acquiring a Foreign Sub*:**_ * Quick entry into the foreign market - don't have to develope a new entity * Known level of operating results and related historical informations * May block o preempt competitors from entering the market _**Disadvantages of *Acquiring a Foreign Sub:***_ * Possible lack of understanding of acquired firm's values, culture, operating processes, etc. * Pre-existing corporate culture may be difficult to integrate with parent. * Synergies or other expected benefits may not materialize **_Establishing a New Foreign Sub:_** * An alternate way to acquiring pre-existing entity * Also called a "Greenfield Venture" * Founding entity is "breaking new ground" _**Advantages of *Establishing New Foreign Sub:***_ * Foreign sub can be built from "ground up" to have desired culture, operating style, and procedures * Parent better be able to transfer organizational compentencies, skills, routines, and culture. _**Disadvantages of *Establishing New Foreign Sub:***_ * Time consuming * More costly than acquisition * Greater risk associated with unknown revenues, costs, and other operating aspects _**\*\*\*\*\*\*Advantages of Foreign Sub *(Both Acquired and Establishing New)\*\*\*\*\*\*:***_ * Parent maintains control over assets and operations * Parent is able to coordinate strategy with other operations and adapt as needed. _**\*\*\*\*\*Disadvantages of Foreign Sub *(Both Acquired and Establishing New)\*\*\*\*\*:***_ * Capital investments most costly of alternatived for engaging in international business * Greater unknowns about outcomes and risks * Costs and risks burden the single parent

Question 99

**Becoming Global: Summary Conclusions**

Answer 99

1. **Importing/Exporting** provides low cost, low risk means of engaging in international business. 2. *When protection of patents, technology processes or other proprietary information is important,* **avoid foreign licensing and joint ventures. The use of wholly owned is a better option** to maintain control of proprietary elements. 3. *When there is a foreign opposition,* **use of joint venture** may avoid some resistance that a wholy owned sub may encounter. 4. *When the home country is pursuing global strategy,* **use of wholly owned sub** may provide the needed integration and operational control not available in other forms of entry into a foreign location. 5. *When there is a need to minimize cost or risk in establishing foreign operations*, the **use of licensing and/or franchising may be desirable.**

Question 100

Becoming Global: Question: Which of the following statements regarding **foreign licensing and foreign franchising**, if any, is/are correct? I. Licensors typically remain more involved with a licensee than a franchisor remains involved with a franchisee. II. Franchising typically provides greater quality control than does simple licensing.

Answer 100

**_II only._** ## Footnote **Franchising** is a special form of licensing in which the franchisor sells intangible assets to a franchisee and mandates strict operating requirements of the franchisee. Thus, **franchising does typically provide greater quality control than simple licensing** (Statement II). **Licensors typically do not remain more involved with a licensee than a franchisor does with a franchisee** (Statement I).