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MANAGING MULTINATIONALS
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Ch-2, RM Joshi
International Trade Theory and Application - Handout given by Prof. Chawla
International Trade Theories
International trade is the exchange of goods and services across borders. Export
structures vary across countries. A number of international trade theories can
explain these different structures.
Comparative Advantage Theory
Heckscher-Ohlin Theorem
Countries export goods that make intensive use of the countrys abundant factor.
Countries import goods that make intensive use of the countrys scarce factor.
Differences in comparative advantage are attributed to differences in the structure of
the economy.
Assumptions:
Countries vary in the availability of various factors of production.
The Production Function is identical anywhere in the world.
The amount of output produced by using any given amount of capital
and labor.
Technology is constant in all trading countries.
Conditions of demand for production factors are the same in all countries.
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Implications
Trade should be greatest between countries with the greatest differences in
economic structure.
Trade should cause countries to specialize more.
Trade policy should take the form of trade restrictions.
Countries should export goods that make use of the abundant factors.
Free trade should equalize factor prices between countries with similar
relative factor endowments.
Factor prices should be nearly equal between countries with more liberal
mutual trade.
International investment should be stimulated by difference in factor
endowments.
Factor endowment theory
A trade theory which holds that nations will produce and export products that use
large amounts of production factors that they have in abundance and will import
products requiring a large amount of production factors that they lack. This theory is
also known as the HeckscherOhlin theory (after the two economists who first
developed it).
Keesing indicated that trade direction and flow is predicted by gaps in human skills
and technology.
Nations with higher levels of humans skills and technology will produce and export
goods to nations with lower levels.
Human Skills and Technology-Based View
Human Skills are predicted by
Level of development in the scientific, technical, managerial, and skilled labor
sectors.
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Product innovation and initial use occurs first in higher income countries
Diffuses to middle and lower income countries as technology and skills gaps
overcome and consumer preferences switch to the newer products.
Several trends emerge in PLC:
The export performance of the mature innovating country is better than
others.
Technology is better in the mature countries as products diffuse production
tends to move from technology-intensive to labor-intensive.
Countries that were innovators can fall from that place.
Trade may increase in later stages of product maturity as costs and prices
decline and production economies rise.
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Theory Assessment
These theories provide insights in international trade.
No theorem can fully explain the range of motives for international trade.
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2).Modern theories Modern theories emphasise the fact that product and factor markets
are imperfect both domestically and internationally and that considerable transactional
costs are involved in market solutions. Also they acknowledge that managerial and
organisational functions play an important role in undertaking FDI.
3).Radical theories - The radical theories, these take a more critical view of Multinational
National Corporation (MNCs).
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Location-specific
TRADITIONAL THEORY
Capital arbitrage theory - The theory states that direct investment flows from
countries where profitability is low to countries where profitability is high. It means
therefore that capital is mobile both nationally and internationally. But sometimes
implication is that countries with abundant capital should export and countries with less
capital should import. If there was a link between the long-term interest rate and return on
capital, portfolio investment and FDI should be moving in the same direction.
International trade theory-the country will specialise in production of, and export those
commodities which make intensive use of the countrys relatively abundant factor.
MODERN THEORY
Product-cycle theory New products appear first in the most advanced economy in
respond to demand conditions. The maturing product stage is described by standardisation
of the product, increased economies of scale, high demand and low price. The
standardised product stage is reached when the commodity is sold entirely on price basis.
Theory Of Appropriability. The theory explains why there is a strong presence of hightechnology industries among MNCs.
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3rd Internalization (I) advantage in order for the firm to transfer its ownership
advantages across national boundary
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Internalisation theory is considered very important also by Dunning, who uses it in the
eclectic theory, but also argues that this explains only part of FDI flows.
Hennart (1982) develops the idea of internalization by developing models between the
two types of integration: vertical and horizontal.
The concept of firm-specific advantages and demonstrates that FDI take place only if
the benefits of exploiting firm-specific advantages outweigh the relative costs of the
operations abroad. According to Hymer (1976) the MNE appears due to the market
imperfections that led to a divergence from perfect competition in the final product
market. Hymer has discussed the problem of information costs for foreign firms
respected to local firms, different treatment of governments, currency risk (Eden and
Miller, 2004). The result meant the same conclusion: transnational companies face
some adjustment costs when the investments are made abroad. Hymer recognized that
FDI is a firm-level strategy decision rather than a capital-market financial decision.
O from Ownership advantages: This refer to intangible assets, which are, at least
for a while exclusive possesses of the company and may be transferred within
transnational companies at low costs, leading either to higher incomes or reduced costs.
But TNCs operations performed in different countries face some additional costs.
Thereby to successfully enter a foreign market, a company must have certain
characteristics that would triumph over operating costs on a foreign market. These
advantages are the property competences or the specific benefits of the company. The
firm has a monopoly over its own specific advantages and using them abroad leads to
higher marginal profitability or lower marginal cost than other competitors.
There are three types of specific advantages:
a) Monopoly advantages in the form of privileged access to markets through
ownership of natural limited resources, patents, trademarks;
b) Technology, knowledge broadly defined so as to contain all forms of innovation
activities
c) Economies of large size such as economies of learning, economies of scale and
scope, greater access to financial capital;
L from Location: When the first condition is fulfilled, it must be more advantageous
for the company that owns them to use them itself rather than sell them or rent them to
foreign firms. Location advantages of different countries are de key factors to
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determining who will become host countries for the activities of the transnational
corporations. The specific advantages of each country can be divided into three
categories:
a) The economic benefits consist of quantitative and qualitative factors of
production, costs of transport, telecommunications, market size etc.
b) Political advantages: common and specific government policies that affect FDI
flows
c) Social advantages: includes distance between the home and home countries,
cultural diversity, attitude towards strangers etc.
I from Internalisation: Supposing the first two conditions are met, it must be
profitable for the company the use of these advantages, in collaboration with at least
some factors outside the country of origin . This third characteristic of the eclectic
paradigm OLI offers a framework for assessing different ways in which the company will
exploit its powers from the sale of goods and services to various agreements that might
be signed between the companies. As cross-border market Internalisation benefits is
higher the more the firm will want to engage in foreign production rather than offering
this right under license, franchise.
Eclectic paradigm OLI shows that OLI parameters are different from company to
company and depend on context and reflect the economic, political, social
characteristics of the host country. Therefore the objectives and strategies of the firms,
the magnitude and pattern of production will depend on the challenges and opportunities
offered by different types of countries.
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2.
3.
4.
5.
A free trade area eliminates all barriers to the trade of goods and services among
member countries
North American Free Trade Agreement (NAFTA) - U.S., Canada, and Mexico
A customs union eliminates trade barriers between member countries and adopts
a common external trade policy
the EU is headed toward at least partial political union, and the U.S. is an
example of even closer political union
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between participating countries. The barriers to trade are not altogether removed, but a
preference is shown towards participating countries in comparison to other countries of the
world. There are departures from WTO in the sense that duties and tariffs are reduced
significantly. WTO aims to have same tariffs and duties in international trade between
countries but in the case of PTA, these tariffs are reduced much more than what
GATT allows.
What is FTA?
FTA stands for Free Trade Agreement, and is considered to be an advanced stage in trade
between participating countries of a trade block. These are countries that agree to
eliminate altogether artificial barriers and tariffs in trade between participating
countries. Countries that share cultural links and geographical links are much more likely
to have a trade block of this magnitude. One such block is European Union where free
trade is practiced between the countries of the union.
What is the difference between FTA and PTA?
The aim of PTA and FTA being similar, thin line dividing these agreements gets blurred at
times but it is a fact that PTA is always a starting point and FTA is the final goal of
participating countries in a trade block. Whereas PTA aims at reducing tariffs, FTA aims
at elimination of tariffs altogether.
Tariff Barriers vs Non Tariff Barriers
Importing goods from foreign countries at cheap prices hits domestic producers badly. As
such, countries impose taxes on goods coming from abroad to make their cost comparable
with domestic goods. These are called tariff barriers.
Tariff Barriers
Tariffs are taxes that are put in place not only to protect infant industries at home, but also
to prevent unemployment because of shut down of domestic industries. There are Ad
Valorem tariffs that are a ploy to keep imported goods pricier. This is done to protect
domestic producers of similar products.
Non Tariff Barriers
Placing tariff barriers are not enough to protect domestic industries, countries resort to non
tariff barriers that prevent foreign goods from coming inside the country.
One of these non tariff barriers is the creation of licenses. Companies are granted
licenses so that they can import goods and services. But enough restrictions are
imposed on new entrants so that there is less competition and very few companies
actually are able to import goods in certain categories. This keeps the amount of goods
imported under check and thus protects domestic producers.
Import Quotas is another trick used by countries to place a barrier to the entry of foreign
goods in certain categories. This allows a government to set a limit on the amount of
goods imported in a particular category. As soon as this limit is crossed, no importer can
import further quantities of the goods.
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Non tariff barriers are sometimes retaliatory in nature as when a country is antagonistic to
a particular country and does not wish to allow goods from that country to be imported.
There are instances where restrictions are placed on flimsy grounds such as when western
countries cite reasons of human rights or child labor on goods imported from third world
countries. They also place barriers to trade citing environmental reasons.
What is the difference between Tariff Barriers and non Tariff Barriers
The purpose of both tariff and non tariff barriers is same that is to impose
restriction on import but they differ in approach and manner.
Tariff barriers ensure revenue for a government but non tariff barriers do not bring
any revenue. Import Licenses and Import quotas are some of the non tariff
barriers.
Non tariff barriers are country specific and often based upon flimsy grounds that
can serve to sour relations between countries whereas tariff barriers are more
transparent in nature.
Trade Creation
This involves a shift in domestic consumer spending from a higher cost domestic
source to a lower cost partner source within the EU, as a result of the abolition tariffs
on intra-union trade. So for example UK households may switch their spending on car
and home insurance away from a higher-priced UK supplier towards a French
insurance company operating in the UK market.
Trade creation should stimulate an increase in trade within the customs union and
should, in theory, lead to an improvement in the efficient allocation of scarce resources
and gains in consumer and producer welfare.
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Trade Diversion
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Types of exposures.
Accounting Exposures
Transaction Exposure
Translation Exposure
Operating / Economic Exposure
Economic Exposure
Economic exposure is the risk to the firm that its long-term cash flows will be affected,
positively or negatively, by unexpected future exchange rate changes.
It emphasizes that there is a limit to a firms ability to predict either cash flows or exchange
rate changes in the medium to long term.
Management of economic exposure is being prepared for the unexpected.
Translation exposure
Translation exposure is the risk that arises from the legal requirement that all firms
consolidate their financial statements of all worldwide operations annually.
Unlike transaction and economic exposures, which are true exposures, translation exposure
is an economic problem.
Transaction Exposure
Risk in adverse movement of exchange rates from the time the
transaction is budgeted till the time of exposure is extinguished by sale / purchase of a foreign
currency against domestic currency
The two conditions necessary for a transaction exposure to exist are:
1. A cash flow that is denominated in a foreign country.
2. The cash flow will occur at a future date.
Impact of Transaction Exposure.
It will be of short term in nature
Will have an impact on cash flow of a company
Managing transaction exposures
Managing transaction exposures usually is accomplished by either natural hedging or
contractual hedging.
Natural hedging describes how a firm might arrange to have foreign currency cash flows
coming in and going out at roughly the same times and same amounts.
Contractual hedging is when a firm uses financial contracts to hedge the transaction
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exposure. The most common foreign currency contractual hedge is the forward contract.
Hedging Transaction Exposure
Since exposure arises due to unanticipated movement of exchange rate , entering into a
financial counter-transaction at a future point in time is known as hedging
The amount receivable (exports) is technically referred as long position
The amount payable ( imports) is technically referred as short position
The basic rule of hedging is:
The payables (short position) in a currency in the future is to be hedged with buying (long
position) in the same currency in the forward; and receivables (long position) in a currency
in the future is to be hedged with selling (short position) the same currency in the forward
Instruments of Hedging
Forward contract
Money market hedge
Future contract
Option contract
Currency invoicing
Exposure netting
Currency Risk Sharing
Forward Contract
A forward contract is an agreement made today between a buyer and a seller to exchange the
commodity or instrument for cash at a predetermined future date at a price agreed upon today.
In a forward contract, two parties agree to do a trade at some future date, at a stated price and
quantity. No money changes hands at the time the deal is signed
Forward contracts are not traded on an exchange, they are said to trade over the counter
(OTC).
The secondary market do not exist for the forward contracts and faces the problem of liquidity
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and negotiability
Forward contracts face counter party risk
The longer the time period, larger is the counterparty risk
Futures Contract
A futures contract is a financial security, issued by an organised exchange to buy or sell a
commodity, security or currency at a predetermined future date at a price agreed upon today
Futures are exchange traded contracts to sell or buy financial instruments or physical
commodities for future delivery at an agreed price
The contract expires on a pre-specified date which is called the expiry date of the contract
On expiry, futures can be settled by delivery of the underlying asset or cash
The futures contract relates to a given quantity of the underlying asset and only whole
contracts can be traded
Currency Futures
Currency Futures means a standardised foreign exchange derivative contract traded on a
recognized stock exchange to buy or sell one currency against another on a specified future
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Future Hedge
Tailor-made contracts
Standardised contracts
Options
An option is a contractual agreement that gives the option buyer the right, but not the
obligation, to purchase (call option) or to sell (put option) a specified instrument at a specified
price at any time of the option buyers choosing by or before a fixed date in the future
The buyer / holder of the option purchases the right from the seller/writer for a consideration
which is called the premium
Call Option :
A call option gives the buyer the right to buy a fixed number of
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shares/commodities at the exercise price upto the date of expiration of the contract
Put Option:
A put option gives the buyer the right to sell a fixed number of
shares/commodities at the exercise price upto the date of expiration of the contract
Options Example
Current price of oil is $65 per barrel. An airlines company feels oil prices might rise 6 months
later & wishes to hold an option to buy oil 6 months hence at, at most $67. An oil refinery feels
prices will fall 6 months later & wishes to hold an option to sell oil 6 months hence at, at least
$67. Both companies approach the exchange and place their orders.
Exchange has options which fulfill the requests at $67 per barrel.
1. What is the expiration period ?
2. Is Airline Company a holder or writer ?
3. Is Oil Refinery a holder or writer ?
4. What option type does Airline Company hold ?
5. What option type does Oil Refinery hold ?
6. What are the Strike Prices ?
Features of Options
The option is exercisable only by the owner, namely the buyer of the option
The owner has limited liability
Options have high degree of risk to the option writers Options involve buying counter positions
by the option sellers
Options are popular because they allow the buyer profits from favourable movements in
exchange rate
Option Benefits
Call
Put
Right to Buy
No Obligation
Premium Pay
Right to Sell
No Obligation
Premium Pay
No Right
Obligation to Sell
Premium Receive
No Right
Obligation to Buy
Premium Receive
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International Diversification
Hedging
Countertrade
Countertrade is a sale that encompasses more than an exchange of goods, services, or ideas
for money.
Historically, countertrade was mainly conducted in the form of barter, which is a direct
exchange of goods of approximately equal value, with no money involved.
Conditions that encourage countertrade are:
lack of money,
lack of value of or faith in money,
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FINANCIAL SWAPS
A swap is a derivative in which two counterparties exchange cash flows of one party's
financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. Specifically, two
counterparties agree to exchange one stream of cash flows against another stream. These
streams are called the legs of the swap. The swap agreement defines the dates when the
cash flows are to be paid and the way they are accrued and calculated.[1] Usually at the
time when the contract is initiated, at least one of these series of cash flows is determined
by an uncertain variable such as a floating interest rate, foreign exchange rate, equity
price, or commodity price.[1]
Interest Rate Swap
In the basic ("plain vanilla") fixed-for-floating rate interest rate swap, one counterparty
exchanges the interest payments of a floating-rate debt obligation for the fixed rate interest
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payments of the other counterparty. Both debt obligations are denominated in the same
currency.
Some reasons for using an interest rate swap are to better match cash inflows and
outflows and/or to obtain a cost savings. There are many variants of the basic interest rate
swap, some of which are discussed below.
The diagram below is an example of a fixed-for-floating interest-rate swap:
Hedging
A hedge is an investment position intended to offset potential losses/gains that may be
incurred by a companion investment. In simple language, a hedge is used to reduce any
substantial losses/gains suffered by an individual or an organization.
A hedge can be constructed from many types of financial instruments, including stocks,
exchange-traded funds, insurance, forward contracts, swaps, options, many types of overthe-counter and derivative products, and futures contracts.
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'Arbitrage' The simultaneous purchase and sale of an asset in order to profit from a
difference in the price. It is a trade that profits by exploiting price differences of identical or
similar financial instruments, on different markets or in different forms.
'Cross Rate' The currency exchange rate between two currencies, both of which are not
the official currencies of the country in which the exchange rate quote is given in.