International Financial MGMT U1

UNIT 1 i
Introduction to international financial management
Unit 1
BBF 308/05
International Financial
Management
Introduction to
International
Financial
Management
ii WAWASAN OPEN UNIVERSITY
BBF 308/05 International Financial Management
COURSE TEAM
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COURSE COORDINATOR
Mr. Lee Kian Tek
EXTERNAL COURSE ASSESSOR

Associate Professor Dr. Law Siong Hook, Universiti Putra Malaysia
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UNIT 1 iii
Contents
Unit 1 Introduction to International
Financial Management
Course overview 1
Unit overview 3
Unit objectives 4
1.1 Managing the Multinational Corporation (MNC) 7
Objectives 7
Introduction 7
The definition of MNC 7
The goals and constraints of an MNC 8
Conflicts against the MNC goal 8
Corporate control and financial management of an MNC 9
Methods to prevent agency problem 11
Constraints interfering with the MNC’s goal 11
Suggested answers to activity 13
1.2 Theories of international business 15
Objectives 15
Introduction 15
Theory of absolute advantage 15
Theory of comparative advantage 17
Imperfect markets theory 19
Product cycle theory 19

iv WAWASAN OPEN UNIVERSITY
1.3 International business methods 23
Objectives 23
Introduction 23
International trade 23
Licensing 23
Franchising 24
Joint ventures 24
Acquisitions of existing operations 24
Establishing new foreign subsidiaries 25
Which mode of entries is the best? 25
1.4 Foreign exchange rate quotations 29
Objectives 29
Introduction 29
Currency quotations in Malaysia 29
Direct quotation 30
Indirect quotation 31
Bid/ask spread 32
Cross exchange rate calculations 33
Forward premiums and discounts calculations 34
Forward premiums and discounts interpretation 35
Cross exchange rates and forward premiums and discounts 35
The exchange rate equilibrium 36
Measuring exchange rate movements 36
Demand for a currency 37

UNIT 1 v
Supply of a currency 38
The exchange rate equilibrium 39
Factors that influence equilibrium exchange rate 41
Speculating on anticipated exchange rate changes 43

Calculating the profit from speculating on 43
anticipated exchange rate changes
Suggested answers to activities 47
1.5 The history of different exchange rate systems 49
Objectives 49
Introduction 49
The pre-classic exchange regime (pre 1870) 50
Classical gold standard (1870 –1914) 50
Interwar period (1915 –1943) 51
Gold-exchange standard or the Bretton Wood system 52

(1944 –1973)
A managed floating exchange rate system (1973 –present) 53
The present currency regimes 54
Fixed versus flexible currency regimes 56
A single European currency 57
Summary of Unit 1 63
Suggested answers to self-tests 67
References 71
vi WAWASAN OPEN UNIVERSITY
UNIT 1 1
Course Overview
T his is a 5-credit, one semester, level 3 (BBF 308/05) core course designed for
students who are enrolled in Bachelor of Business Banking & Finance (Hons.)
degree programmes. There are a total of five units in this course.
Unit 1 introduces you to the various types of international business. This is

followed by a brief introduction to foreign exchange market and system. Currently,
most countries are either practising the free float or managed float system. As
such it is important for you to be able to interpret exchange rate quotation and
analyse the factors that lead to exchange rate equilibrium
With the basics from Unit 1, Unit 2 focuses on the various principles and
currency strategies applied in foreign exchange market to create arbitrage profit.
Based on the principles of interest rate parity, international Fisher’s effect and
purchasing power parity, the relationship between interest rate, inflation and
exchange rate is established.
Unit 3 deals with the three types of exposure that an international firm is
exposed to in their daily operations. To minimise their exchange rate risk in the
volatile currency market, various hedging technique can be applied. The hedging
techniques will require the application of financial derivatives instruments like
forward, futures and swaps.
Unit 4 deals with the feasibility study of an international project. What are the
factors that have to be considered before investing in foreign countries? The
feasibility study will be viewed from two perspectives, namely, quantitative
and qualitative. The quantitative refers to multi national budgeting while the
qualitative factor refers to country risk analysis. In addition, the topic will also
discuss strategies to minimise government nationalisation.
Unit 5 discusses the various short term financing alternatives by Multinational

Companies (MNCs). The main objective is to minimise the cost of funding, hence
maximising the firm’s and shareholder’s value in the long run. In addition, it also
deals on methods to optimise cash flow of the firm and discuss the benefits and
risk of foreign direct investment.
By the end of this course, you should be able to:
1. Gain an overview of the various types of exchange rate system.
2. Gain an overview of international business strategies.
3. Apply the theories of interest rate parity in the foreign exchange market.
4. Execute arbitrage and speculative currency strategy in the spot and

forward market.
2 WAWASAN OPEN UNIVERSITY
5. Evaluate the feasibility of long-term multinational international project.
6. Effectively manage a firm’s exposure to foreign exchange rate risk in its

balance sheet and operations.
UNIT 1 3
Unit Overview
I nternational business activity is not a new phenomenon in world economics.

The transfer of goods, services and even factors of production such as capital
and labour across national borders has been taking place for thousands of
years in human history. Over the last 20 years, however, the business world
has become more globalised. With technological advancement in information,
telecommunication and transportation, different parts of the world have come
closer to each other. At the same time, every business has received direct or indirect
impact from a globalised environment. These include the import and export of
final products, intermediate inputs (including materials and components), and
even services (like providing or giving consultations). Some domestic firms even
obtain franchise from foreign brands while some others license foreign firms to
conduct their foreign business.
Even if a corporation attempted to focus on domestic operations only, it would be

forced to compete with competitors who may have international aspects to their
operation. For instance, a local corporation in Malaysia that only manufactures
and sells garments locally may face stiff competition from competitors that
import foreign-made garments from China. There is no such thing as a ‘pure
domestic’ corporation any more! This type of indirect effect is highly dynamic in
the sense that the presence of these foreign competitors is mostly unpredictable,
and sometime the competition can be very costly. Therefore, domestic firm
managers should not take for granted the closed environment that they still
enjoy right now. They need to understand and be aware of the international
environment, especially labour costs, inflation, and the international financial risk
that relates to foreign exchange rates, credit risks that relates to trade payments
and other types of financial uncertainties.
For this unit, let us start by looking at what international financial management
is all about. We do not have to go to a big dictionary to look up a lengthy
definition. Simply put, international financial management is the financial
management practices of a multinational corporation (MNC). Although the
definition of international financial management sounds simple, we have to
integrate all possible international impact upon a multinational corporation.
Managers of MNCs must understand the international environment and

the study guide in order to make proper business decisions. They must be
ready in making decisions about market-entry strategy, ownership of foreign
operations, production in foreign environment, marketing in societies of different
cultures, international investing and financial decisions that are intended
to maximise the value of the MNC as a whole.
Obviously, you need to understand financial management in a complex

environment, and thus you need to have a good knowledge of the following
areas:
• international financial markets
• macroeconomics
• microeconomics
• sociology and political science
• culture, history and institutions
• legal aspects of business
• accounting
• marketing
• management
In this unit, you will learn some basic terms and concepts related to international
financial management as well as the functioning of the exchange rate system.
First, you will consider the goals of a multinational corporation (MNC) and the
various constraints that may affect it. Then you will be briefly introduced to three
different theories of international business and different international business
methods. Third, you will study foreign exchange rate quotations, cross exchange
rates and forward premiums or discount calculations, the meaning of exchange
rate equilibrium, profit from speculating on anticipated exchange rate changes,
and a brief history of the different exchange rate systems.
Unit Objectives
By the end of Unit 1, you should be able to:
1. Discuss the corporate goals of a Multinational Corporation (MNC).
2. Discuss the various constraints that may affect the goals of an MNC.
3. Compare and contrast different theories of international business.
4. Analyse how these theories promote international trade.
5. Compare and contrast different international business methods.

UNIT 1 5
6. Interpret foreign exchange rate quotations.
7. Calculate cross exchange rates and forward premiums or discounts.
8. Interpret the meaning of exchange rate equilibrium.
9. Calculate the profit from speculating on anticipated exchange rate changes.
10. Discuss the history of different exchange rate systems.
11. Discuss the fixed and flexible exchange rate regime.
12. Discuss the Euro currency.

UNIT 1 7
1.1 Managing the Multinational

Corporation (MNC)
Objectives
By the end of this section, you should be able to:
1. Discuss the goals of a Multinational Corporation (MNC).
2. Discuss the various constraints that may affect the goals of an MNC.
3. Discuss the various methods to overcome these constraints.
Introduction
Before going further in studying international financial management, we first
need to discuss about the multinational corporation (MNC). Understanding
the corporate goals of an MNC and the various constraints faced by an MNC
in achieving its corporate goals essentially leads to the answer why international
financial management is important to an MNC.
In the following sections, we will define MNC and its corporate goals, and
elaborate the problems faced by an MNC in achieving its corporate goals.
The definition of MNC

MNC is defined as a corporation that have business engagement across national
borders. An MNC produce, distribute and sell the product of their business,
including both goods and services, in many countries or even in the whole
world. They often have operating subsidiaries, branches, or affiliations located
in many countries. For firms in the service industry, their activities include
consulting, accounting, construction, legal, advertising, entertainment, banking,
telecommunications, utilities and lodging. Most of the MNCs are headquartered
all over the world. The ownership of some MNCs is so dispersed internationally,
where the corporate is owned by both local and foreign shareholders. For
this type of MNC, they are known also as transnational corporations. These
transnational corporations are usually managed from a global perspective rather
than from the perspective of any single country.
The goals and constraints of an MNC

Essentially, the main goal of an MNC is to maximise shareholder wealth. However,
as you will learn, MNC managers face environmental, regulatory and ethical
constraints that can conflict with this goal. The case at the end of the section
illustrates the ethical constraints facing a lot of MNCs nowadays.
In seeking to maximise the wealth of its shareholders, an MNC is no different

from a domestic corporation. However, an MNC faces more challenges than a
domestic corporation because of the international environment of its business
relationships. These challenges sometimes make the goal of shareholder wealth
maximisation more difficult.
Conflicts against the MNC goal

One of the main factors threatening the MNC goal is the agency problem. The
separation between the shareholders and managers in the corporation often
results in the conflict of goals. As you may know from doing courses on business
finance, this refers to the fact that the management of a corporation is only an
agent for the shareholders. If managers of a corporation put more emphasis on
their personal well-being than on shareholder wealth, then shareholder wealth will
not be maximised. For instance, if the general manager of a corporation spends
too much time playing golf during business hours instead of holding important
business meetings, you will not expect the performance of the corporation to be
very good.
For an MNC, the agency problem could be even worse than a domestic corporation.
Consider an example: A Malaysian MNC with a manufacturing facility in
mainland China is making electronic products for export. It is extremely hard for
the general manager in the MNC’s Malaysian headquarters to oversee every step
of the manufacturing facility in mainland China. So it is possible for the local
manager in China to make decisions that are not consistent with shareholder
wealth maximistion. The nature of this type of ‘long distance’ or ‘remote control
type’ management often causes serious agency problems.
UNIT 1 9
Another example would be the subsidiary chief in a foreign country who only
considers his or her localised operation without paying attention to the impact of
its foreign country operation upon the entire corporation.
Such agency problem is less likely to occur if the firm has only one owner who is
also the sole manager. The manager of the business, who also is the owner, is more
likely to choose to maximise the firm value for whatever business he undertakes.
The financial and non-financial costs of ensuring that managers maximise firm
value or shareholder wealth (referred to as agency costs) are normally larger for
MNCs than for purely domestic firms. This is due to several reasons:
First, MNCs have subsidiaries scattered around the world. With wider
geographical coverage, this surely invites larger agency problems. To monitor
foreign managers from distant subsidiaries, this consumes higher communication
costs. Moreover, in most instances, their foreign subsidiaries are managed by
home managers and are located in a country with a different time zone; hence
the need for specific arrangement for communications is very common. Of
course, with the advance telecommunications technology that we have today, such
problem is no longer a critical issue.
Second, foreign subsidiary managers are often foreigners that come from a
different background of cultures and trained in a different foreign education
system. Thus, they may not follow uniform goals of the MNCs as in the home
country. They might have different interpretation and understanding on the
corporate culture of the host company.
Last but not least, relative to domestic firms, MNCs are huge in business scale
and corporate size, and have a wider range and scope of business. This suggests
that MNCs have to face a more complex management control. As a result, they
are likely to be exposed to more agency problems.
Corporate control and financial management of an MNC

The agency problem that exists for management control is also a problem
inhabited in organisation management of the company as a whole. To prevent the
agency problem, however, MNCs need to ensure that the company environment
is not over regulated. They must ensure the organisation management is well
motivated for the managers and workers, and a good rewards system is ready
to compensate good performance. In this case, management of an MNC must
decide whether the MNC uses a more centralised management control in
order to minimise the agency problem, or whether it uses a more decentralised
management control in order to let the local subsidiary have more flexibility and
more creative business decisions.
Under a centralised management control, as shown in Figure 1.1 on the financial

management structures of MNCs, the agency problem can be minimise because
the financial managers from the parent MNC can have direct control to oversee
the operation and management of every department in both subsidiaries A and
B. However, in this case, the financial manager from the parent MNC might
make poor operation and management decisions for both the subsidiaries
if he is too busy to keep himself fully informed on the progress of both the
subsidiaries.
On the other hand, under the decentralised management control, as illustrated

in Figure 1.2, the financial manager of the parent MNC only get reports from
the two subsidiary financial managers, instead of overseeing all the departments
in both subsidiaries. This style of management control of course is likely to
result in higher agency cost because the subsidiary financial managers may make
decisions not focusing on maximising the corporate value of the parent MNC.
The decentralised management control will only be effective if the parent MNC
can ensure the subsidiary financial managers recognise the goal of maximising the
overall MNC value.
Financial Manager of Parent MNC
Subsidiary Manager A Subsidiary Manager B
Cash Management A Cash Management B
Capital Management A Capital Management B
Investment Investment
Management A Management B
Figure 1.1 Centralised multinational financial management for subsidiaries A and B
Financial Manager of Parent MNC
Subsidiary Manager A Subsidiary Manager B
Cash Capital Investment Cash Capital Investment

Management Management Management Management Management Management
A A A B B B
Figure 1.2 Decentralised multinational financial management for subsidiaries A and B

UNIT 1 11
Methods to prevent agency problem

To reduce the agency problem, MNCs can employ various forms of preventive
methods. At the management level, a proper corporate governance practice
is useful. The control of the agency problem very much relies on the level of
corporate governance practised in the parent corporation. More importantly,
it also relies on the effectiveness and clearness of the parent corporation to
communicate the corporate goals to each subsidiary to ensure all subsidiaries
focus on maximising the value of the MNC rather their respective subsidiary
values. The parent company can implement compensation plans that reward
the subsidiary managers who satisfy the MNC’s goals. A common incentive is to
provide managers with the MNC’s stock option on top of their salary
compensation, so that they benefit directly from a higher stock price when they
make decisions that enhance the MNC’s value. Stock option is one of the best and
common practised forms of corporate control. This strategy may also effectively
be used to motivate the lower level workers.
At the industry level, if the MNC’s managers make poor decisions that reduce
the company value, another firm may be able to acquire it at a low price and the
weak managers will likely be removed. This form of corporate control is called
the threat of a hostile takeover. If the company is badly or inefficiently run, stock
market analysts and investors will sell the shares of companies, leading to a fall
in the share price of the company. This opens an opportunity for other firms, or
even competitors, to acquire the firm at a low price. More often than not, the new
owner is likely to replace the existing directors. This threat however, is not really
meaningful in many countries because of local law and regulation set by the local
governments to protect their workers.
Another form of corporate control is monitoring by big shareholders. Institutional

investors such as investment trusts, mutual funds, pension funds and insurance
companies, usually have large holdings of an MNC’s stock. As a result, they always
have influence over company management. If managers make poor corporate
decisions, these pressure groups can complain to the board of directors to remove
the managers. The mode of monitoring is usually by means of the financial
press, annual and interim company reports and, rather more controversially, by
investor briefings given by companies during the annual general meeting (AGM).
Constraints interfering with the MNC’s goal

There are three possible types of constraint that might interfere with the MNC’s
goal:
1. Environmental constraints. These occur when the MNC is required to

comply with building codes, disposal of production waste materials and
pollution control restrictions. Nowadays, more and more countries are
imposing strictly anti-pollution laws for which MNCs have to bear
additional costs. As a result, the MNC has to be very sensitive to these new
legal restrictions. Some MNCs have started to incorporate this green
awareness into their corporate goal and business undertakings.
2. Regulatory constraints. Each country has its own regulatory rules. These
rules include tax laws, currency convertibility rules, employee rights and
earning remittance restrictions, among others. Since the regulations can
have an impact on the company’s cash flows, financial managers must thus
consider them when assessing their business policies and corporate projects.
3. Ethical constraints. There is no common consensus on ethical standards.

Sometimes, it is perfectly legal to do something in one country but illegal
in another country. The ethical issue is also very much to do with the
religion and culture adopted by the local community. MNC should pay
high regards to the ethical standards in the host country so to avoid any
possible offenses.
Activity 1.1
Sam Lee is a senior engineer who oversees his company’s new

manufacturing facility in Shenzhen, mainland China. The factory
has been completed but has not received approval to open shop. It
requires the local fire department’s inspection for safety.
One day Sam’s boss tells him, ‘Sam, we need our factory to
operate as soon as possible, otherwise we shall lose $1m a day’.
‘The local fire department is really busy. They need six months
before they can send their inspectors to inspect our factory,’ replies
Sam.
‘Well, we need to do something,’ his boss says. ‘I have an idea,’

his boss continues. ‘I know the local fire chief. He used to be my
high school buddy. I’ll give him a call. I know his son is going to
study in the US and we can offer his son some help through our
US subsidiary. This should take care of the inspection. Let us have
dinner together.’
Sam is uneasy about his boss’s arrangement. He understands that

his boss is trying to bribe the local fire chief. However, Sam’s
corporation cannot afford to lose $1m a day and a total of $180m
over the six-month waiting period. Sam is confused and he does
not know what to do.
1. Which particular constraint (or constraints) against shareholder

wealth maximisation does the above case illustrate?
2. If you were Sam’s good friend, what would you advise him
to do?
UNIT 1 13
Summary
This completes the first section of Unit 1. In this section you have
been introduced to the background and basic concepts in managing
an MNC, including the definition of MNC, the corporate goals of
MNC and the challenges in achieving these goals. Discussions in
later units will be based on the perspective of MNCs.
Self-test 1.1
1. The North American Free Trade Agreement (NAFTA) enables

Canada, Mexico and the US to eliminate trade barriers
gradually. It is expected that US-based MNCs are able to
have new opportunities and at the same time more risk.
Briefly explain these opportunities and the risk.
2. Following the terrorist attack on the US the valuations of

many MNCs declined by more than 10 percent. Explain why
the expected cash flows of MNCs were reduced, even if they
were not directly hit by the terrorist attacks.
3. Why is it that political risk may discourage international

business?
Suggested answers to activity
Feedback
Activity 1.1
1. The case illustrates how legal constraints may be against

shareholder wealth maximisation. Sam’s boss’s bribery is
illegal. However, if his boss follows the rules, his company
may incur a loss of $180m.
2. You should advise him either to quit the job or at least not to
be involved in such illegal activities.
UNIT 1 15
1.2 Theories of International Business

Objectives
1. Compare and contrast the four basic theories of international business.
2. Analyse how these theories promote international trade.
Introduction
All economies, regardless of their size, depend to some extent on other economies
and are affected by events outside their borders. In this section, we turn to
theories of international business with the aim of gaining an understanding of
what motivates MNCs to go beyond the domestic market to do business across
borders. We shall look at four theories:
• The theory of absolute advantage
• The theory of comparative advantage
• The imperfect markets theory
• The product cycle theory.
No one theory can explain all. Sometimes, one theory works better than the others
given a particular set of circumstances. Let us look at them one by one, then you
can work on the activity at the end of the section, in which a newspaper extract
from the Wall Street Journal describes how Taiwan’s chipmakers adjust their
international business strategy.
Theory of absolute advantage

The theory of absolute advantage is perhaps the most important theory in
international trade. It was first formally introduced by Scottish economist Adam
Smith (1723 – 1790) and it remains one of the most important foundations in
the explanation and justification for international trade. The theory of absolute
advantage asserts that a country benefits from producing more output than others
from the possession of a particular resource or commodity. This particular resource
refers to knowledge or production technology that increases the production
efficiency of the output, in other words. In short, under the absolute advantage
concept, the theory of international trade is basically referring to the best way to
minimise the absolute cost of production.
Assuming we have only two countries in this world, Malaysia and Singapore,
producing two commodities, food and cloth as illustrated in Figure 1.3. Suppose
that Malaysia is more efficient at producing food, and Singapore is more efficient
at producing cloth. If Malaysia chooses to channel 100% of its resources to
produce food, the total quantity of food produced is 1,000 units but if 100%
resources are channelled to produce cloth, the total amount produced is only 200
units. On the other hand, with 100% of resources, Singapore managed to produce
only 800 units of food but if 100% resources are channelled to produce cloth,
the total amount of cloth output is 400 units.
Without international trade, assume that both countries have allocated half
of its production resources (labour, capital and material) to produce the two
commodities in order to fulfil the needs of their people. For the given knowledge
or production technology of the economy of Malaysia, the total amount of
food and cloth produced by Malaysia is 500 units and 100 units, respectively.
For Singapore, the knowledge or production technology available allows a
production of 400 units of food and 200 units of cloth. As mentioned above, a
country enjoys an absolute advantage over another country in the production of
a product when it can produce a better quantity of that product than the other
country does. In this case, Malaysia thus has the absolute advantage in producing
food and Singapore has the absolute advantage in producing cloth. The total
world production of food is 900 units (500 from Malaysia and 400 from
Singapore), and the total world production of cloth is 300 units (100 from
Malaysia and 200 from Singapore).
The output of food and cloth can be increased by specialisation and international
trade. This means Malaysia should produce more food than it needs at the expense
of some cloth production; and Singapore should produce more cloth than it needs
at the expense of some food production. Malaysia can then trade some of its
surplus food for some of Singapore’s excess production of cloth. To see the impact
of international trade clearly, let us assume that both countries fully understand
the benefit of specialisation and thus channel 100% of its recourses to produce the
food, while Singapore put 100% of its resources to produce cloth. With double
the quantity of the resources used, Malaysia has produced 1000 units of food,
while Singapore has produced 400 units of cloth. As Malaysian only consumes
500 units of food, the 500 units surplus is exported to Singapore. Similarly,
Singaporeans only need 200 units of cloth. So the extra 200 units are exported to
Malaysia. After the international trade (export and import), Malaysia now
enjoy 500 units of food and 200 units of cloth  an increase of 100 units of
cloth; while Singapore also enjoy 500 units of food and 200 units of cloth  an
increase of 100 units of food. The specialisation and trade between Malaysia and
Singapore on their best produced commodities has benefited both, by allowing
them to enjoy higher quantity of commodities and allows resource to be used
more productively. The total world production of food is 1000 units (100 units
increased), and the total world production of cloth is 400 units (also 100 units
increased).
UNIT 1 17
Malaysia Singapore
Product Food Cloth Food Cloth

Given technology 1000 200 800 400
(100% (100% (100% (100%
resources) resources) resources) resources)
Before international 500 100 400 200
trade (50% (50% (50% (50%
Specialisation 1000 0 0 400
(A in food, B in cloth) (100% (100%
resources) resources)
After international 500 200 500 200
trade: (own (imported) (imported) (own
A exports food to B production) production)
B exports cloth to A
Figure 1.3 Absolute advantage
Theory of comparative advantage

The theory of comparative advantage is the same as the one that we learn in
macroeconomics or international trade. It is usually attributed to David Ricardo
who explained the concept of comparative advantage firstly in his 1817 book
 On the Principles of Political Economy and Taxation. Comparative advantage
means that some countries can produce some goods or services more cheaply and
therefore more efficiently, than others. Usually, these comparative advantages
cannot be transported to other countries. Therefore, MNCs need to expand in
the countries which hold the comparative advantage to take advantage of the
efficiency. For instance, Taiwan has successfully developed its computer chip
industry. The cost of producing computer chips is low in Taiwan relative to other
parts of the world. So a lot of US chip makers, such as Intel, take advantage of
Taiwan’s comparative advantage and establish facilities there to make chips and
export them to the rest of the world.
To see how the theory of comparative advantage differs from absolute advantage,
let us continue with the above case on Malaysia and Singapore. Let us remain all
the assumptions and the related information as above, except that now if Malaysia
chooses to channel 100% of its resources to produce cloth, the total quantity of
cloth produced is 450 units. This is illustrated in Figure 1.4. In this case, Malaysia
thus has the absolute advantage in producing both food and cloth. Does this mean
Malaysia should not go for specialisation and exclude itself from having trade with
Singapore?
In this case, without international trade, and with half allocation of production
resources to both commodities, the total amount of food and cloth produced by
Malaysia is 500 units and 225 units, respectively. With similar resource allocation
in Singapore, the production is 400 units of food and 200 units of cloth. Now,
the total world production of food is 900 units (500 from Malaysia and 400
from Singapore), and the total world production of cloth is 425 units (225 from
Malaysia and 200 from Singapore).
Let us assume that Malaysia specialises to produce food, while Singapore specialises
to produce cloth. With full resources, Malaysia now produced 1000 units of
food, while Singapore produced 400 units of cloth. Malaysia then exports 500
units of surplus food to Singapore and Singapore exports 200 units of surplus
cloth to Malaysia. The two nations now can engage in international trade with
each other. With international trade, Malaysia can enjoy 500 units of food and
200 units of cloth  a 25 units drop in cloth; while Singapore enjoy 500 units of
food and 200 units of cloth  an increase of 100 units of food. In this case, has
international trade brought any benefit to Malaysia and Singapore? The answer
is positive as the specialisation and trade between Malaysia and Singapore allows
the total welfare of world production to increase in general. Now the total world
production of food is 1,000 units and the total world production of cloth is
400 units.
Recall from the above paragraph that the world total production without international
trade is 900 units of food and 425 units of cloth. Thus, there are 100 units increase
in food, a trade-off by a cut of 25 units of cloth. Is this worthwhile? Well, before
international trade, the price of 1 unit of cloth is 2.12 units of food (900 foods /
425 cloths), but now the world is gaining 100 units of food for losing 25 units of
cloth, i.e., the price of losing the 25 units of cloth is higher as compared to before
having international trade.
Terms of trade is defined as the ratio of the price a country receives for its export
to the price it pays for its import. In this simple case, the import of Malaysia is
simply the export of Singapore, so the term of trade is 2.5 food for every unit of
cloth (500 food/200 cloth). Before international trade, the price of 1 unit of cloth
in Malaysia is 5 units of food, so the trade-off is 5 units of food for every unit of
cloth; while in Singapore the trade-off is 2 unit of food for every unit of cloth.
Note that as long as the terms of trade during international trade is between the
range of the trade-off terms in both countries, there will be welfare gains from
specialisation and international trade even if one country has absolute advantage
in both commodities.
UNIT 1 19
Malaysia Singapore
Product Food Cloth Food Cloth

Given technology 1000 450 800 400
(100% (100% (100% (100%
Before international 500 225 400 200
trade (50% (50% (50% (50%
Specialisation 1000 0 0 400
(A in food, B in cloth) (100% (100%
resources) resources)
After international 500 200 500 200
trade: (own (imported) (imported) (own
A exports food to B production) production)
B exports cloth to A
Figure 1.4 Comparative advantage
Imperfect markets theory

The world suffers from imperfect market conditions where the factors of
production are very often immobile across countries. The process of transferring
labour and other factors of production often incur high transportation costs and
other direct and indirect entry restrictions. The same happens on the transferring
of funds and investment among countries. For instance, mainland Chinese
workers cannot freely enter Hong Kong to work for local manufacturers, so the
only way for Hong Kong MNCs to take advantage of the lower labour costs in
mainland China is to base their production plants there.
The line of this theory was developed in the 1960s and 1970s by Kindleberger
(1969), Hymer (1976) and Buckly and Casson (1976), which argues that it is
because of the imperfection of the market that MNCs are able to take advantage
on organisational efficiency to compete with the local firms and internalise the
imperfect market structure. Dunning (1973, 1988) further synthesised and
developed the general version of this theory.
Product cycle theory

This is a theory encountered in marketing. Essentially, the theory suggests that a
product will exhibit a cycle of super growth, steady growth, and mature (saturated)
stages in sales (or other variables). Therefore, an MNC needs to position its
international business given the respective stage of its products in the product
cycle. In our case of explaining MNCs’ expansion into foreign countries, it is quite
similar. First, an MNC creates products in the home country. The MNC sells its
products locally and exports overseas. As the product becomes mature or is in the
steady growth stage, competitors follow. In order to further lower the production
cost and maintain market share in foreign markets, the MNC usually has to
expand into foreign countries in the hope of out-competing its competitors.
As illustrated in Figure 1.5, there are three stages in the product cycle theory. In
the beginning innovation stage, product creation and development are mainly
tailored to meet the needs of the local market. The production design at this stage
requires more flexibility, highly skilled labour is needed, and intensive capital
investment is consumed. As a result, the business cost of operating at this stage
is very high. The product is yet to be standardised.
As the market expands, its production process becomes increasingly mature and
the need for production flexibility and the demand for highly skilled labour start
to decline. In this maturity stage, new competitors emerge with slight variations
in the product. The increased choice of products in the market allows price
competition, and exerts downward pressure on profits margins. Also, the product
has reached out to foreign market.
In this final stage, the product is completely standardised in the market. With
fierce competition in the market place at this stage, the profit margin is very low.
To maintain the profit margin and market share, companies have to go out to
countries with cheaper labour or cheaper capital to lower the cost of production.
Foreign sales
Stage III: Optimum international

market, cost efficiency needed,
international production plants
Maturity stage:
Export-orientated
Innovation stage:
Product created for
local needs
Time
Figure 1.5 Stages of the product cycle
Activity 1.2
Read the following news report and answer the questions.
Taiwan PC makers rely more on mainland China
Product shortages and higher prices in the personal computer

industry ahead of the Christmas season may yield an unlikely
winner: mainland China.
UNIT 1 21
Even before Taiwan’s big earthquake last month, cut-throat

competition in the low-priced PC market had forced this island’s
companies, which rank as the world’s No. 3 makers of PC
equipment, to move production lines overseas to spare cost. About
29% of Taiwan’s $33.8 billion in PC-hardware production last
year rolled out of plants on the mainland, where land and labour
are cheaper than at home.
Among the big PC companies in Taiwan putting money into the

mainland is Acer Inc., a major supplier to International Business
Machines Corp. and one of the world’s 10-biggest PC makers.
In order to drive down production costs, many PC-related goods

are increasingly being standardised, making it possible for low-wage,
low-skill Chinese workers to handle the job.
Source: Russell Flannery, Wall Street Journal, October 21 1999, A16
1. Describe a theory of international business that explains why

Taiwan’s computer firms moved their production to mainland
China.
2. Briefly explain why these Taiwanese computer firms standardised

their production process.
Summary
This completes the second section of Unit 1. The four theories

discussed in this section form the foundation of international
business. The first two theories are basically macro-orientated.
The two theories looked at the welfare of the world in general and
proposed that international trade could ensure full utilisation of
national resources to achieve higher welfare for peoples. The other
two theories are micro in nature, in the sense that they focused on
market and firm level reasoning in explaining why firms have to go
beyond national borders to expand their business.
Self-test 1.2
1. Coca-Cola has overseas sales at about 66% of its total

company sales. It has been quite successful in expanding
into mainland China, Russia, and African countries. When
Coca-Cola sells its drinks overseas, it does not produce the
drinks in the US and export them to foreign countries.
Instead, it makes the drinks in foreign host countries and
sells the drinks locally. Briefly use one of the theories of
international business to explain such a phenomenon.
2. What factors cause some firms to become more internationalised

than others?
3. Offer your opinion on why the Internet may result in more

international business.
Feedback
Activity 1.2
1. This is an example of the imperfect markets theory. To take

advantage of the low labour and land costs in mainland
China, the Taiwan computer firms have to move to mainland
China to be near the factors of production.
2. The labour quality in mainland China is still not as good as

in Taiwan. By standardising the production process, the
Taiwan computer firms would find it easier to train the
workers as well as simplify the production process. Once the
production process is simplified, it will be easier to control
the quality of the computer products.
UNIT 1 23
1.3 International Business Methods

Objectives
1. Compare and contrast among different international business methods.
2. Discuss the suitability of each method in international business environment.
Introduction
So far we have looked at the goals and constraints of an MNC, and considered
briefly four theories of international business. Let us now turn to the topic of
international business methods. It is important to look at international business
methods because being an MNC manager; you have to be informed of what
options of business operations are available to your company. The knowledge
of alternative business methods for achieving similar or even identical goals is
valuable in the decision-making process.
There are a number of international business methods. You will briefly study a
few characteristics of each method in this section. At the end of the section, you
will study how China Light & Power expands its business in other countries.
International trade
This is a conservative approach. An MNC can simply import from and export to
foreign countries to engage in international business. The risk is small since the
MNC does not place any of its capital at risk. If the foreign country suddenly
becomes politically unstable, the MNC simply stops doing business with its trade
partners there. Under this method, the MNC can maintain tight quality control
standards over the production process as well as its inventory level.
Licensing
In a licensing agreement, an MNC is obligated to provide its technology to
foreign corporations for a fee, known as royalties for some of the technology
including copyrights, patents, trade names or legal right, and trademarks, among
others. The MNC is called the licensor while its foreign counterpart is called
the licensee. For instance, Sprint Corporation (a major US phone company)
has a licensing agreement to develop telecommunications services in the United
Kingdom. Licensing allows the MNC to use its technology in foreign markets
without a major investment in foreign countries and without bearing the
transportation costs that result from exporting or importing. Also, licensing
only requires minimal investment, besides having low exposure to a foreign
environment. As the MNC does not enter the foreign market directly, the time
needed to engage in the foreign market is also kept to a minimum. However, the
negative side of licensing is that the firm will find it difficult to ensure quality
control in the foreign production process. The licensor may also face difficulty
controlling the foreign re-packaging and marketing aspects of the product by the
foreign licensee in the foreign market.
Franchising
Franchising is a special form of licensing. Under this entry method, the product
and services provided by the MNC include brand name or trademark, procedures,
and marketing strategies. In this case, the MNC is the franchisor while the foreign
counterpart is the franchisee. In a franchising agreement, the MNC is obliged to
provide its specialised sales or service strategy, support assistance, and sometimes
an initial investment in the franchise in exchange for a periodic fee. For instance,
Pizza Hut has a franchise agreement with a Hong Kong company. The Hong Kong
company is able to use Pizza Hut’s pizza baking methods and operation strategy
to operate pizza restaurants. Like licensing, franchising allows a firm to penetrate
foreign markets without a major investment in foreign countries. The recent
relaxation of barriers in foreign countries throughout Eastern Europe and South
America has resulted in numerous franchising agreements.
Joint ventures
A joint venture is a company that is jointly owned and operated by two or more
corporations. Many MNCs penetrate a foreign country by engaging in joint
ventures with local corporations. The form of joint venture include pooling of
capital, production facility or marketing equipment, patents, trademarks, or
management expertise. The corporate relationship under joint venture is more
permanent than export or contract manufacturing. For instance, Toyota and
General Motors have a joint venture plant in California producing small cars (both
Toyota Corolla and Chevrolet Prism). Usually the partners in joint ventures have
their own comparative advantages in technology, sales, or other areas. Compared
with international trade, licensing, and franchising, joint ventures require more
direct foreign capital investment. In addition, some legal aspects of the joint
venture arrangement have to be resolved. The weakness in joint venture is the
loss of control over production and marketing quality standards when dealing
with host-company management.
Acquisitions of existing operations

MNCs can gain full control of a foreign company by buying the company. As
long as there are no legal complications in the foreign country, this is a quick and
direct method of engaging international business. The acquisition of an existing
corporation is one of the faster ways to enter a foreign market. MNC can protect
itself from adverse action from the host government of the acquired company.
The problem with this method is that the price of acquisition might be too
UNIT 1 25
high and a potential risk involved is the unforeseen troubles with the acquired
company. It has to remember that the business information is asymmetric where
only the existing company owner has thorough knowledge of the business, so the
selling price might be a lot higher than the buyer’s valuation. Moreover, in some
countries, such as mainland China, the acquisition of a company sometimes needs
a long time to get approved. In the case of partial international acquisition, firms
will not have complete control over the foreign operation.
Establishing new foreign subsidiaries

Last but not least, an MNC may penetrate a new foreign country by establishing
a new foreign subsidiary there. This method requires a large investment. When
an MNC needs tailor-made operations in a foreign country, it is usually very
difficult to have acquisition of existing companies in the foreign country.
Which mode of entries is the best?

Methods such as licensing and franchising involve little or low capital investment
but need to distribute some of the profits to other parties. While acquisition of
foreign firms and formation of foreign subsidiaries are popular, these methods
involve a substantial capital investment but offer the potential for large returns.
There is no clear answer which method is the best. Every method has its
advantages at the different stages of business expansion but then it may invite
greater challenges when the business expansion has gone to the next level.
Figure 1.6 summaries the stages of international business methods. The stepladder
implies that the first and easiest entry mode is international trade, followed by
licensing, franchising, joint ventures, acquisitions of foreign firms, and formation
of foreign subsidiaries.
High
Establishing new
foreign subsidiaries
Acquisitions of
existing operations
Product
Joint venture
Franchising
Licensing
International
trade
High
Low
Market complexity
Figure 1.6 Stages of foreign entries

Activity 1.3
Read the following news article and answer the questions.
CLP moves to power Asia with advantages in ‘our own backyard’
CLP Power International, a subsidiary of CLP Holdings (China

Light Power), is stepping up its Asian investments in countries
whose governments are loosening their control over power
generation and transmission.
‘We are today submitting a bid on a Tasmanian cable project,’

managing director Kenneth Oberg said yesterday.
The Australian government estimates the undersea transmission

cable project, the Basslink power transmission power project,
connecting Tasmania with mainland Australia, has a contract
value of between US$200 million (HK$1.56 billion) and US$300
million, Mr. Oberg said.
The Hong Kong company has teamed up with New South Wales’
state-owned TransGrid and American Electric Power Co. to bid
for the project. The winning tender will be announced on 28
February.
This project comes just three weeks after the company signed a
share sale and purchase agreement with YTL Power International
of Malaysia. CLP Power International acquired a five per cent
stake in YTL for US$102 million. ‘This was a strategic investment
and cooperation agreement,’ Mr. Oberg said. ‘There will be
significant growth opportunities in Malaysia as the government
divests in the industry.’ The two firms plan to jointly bid for
power projects on a 60:40 per cent basis with YTL power holding
the majority stake.
Source: Hong Kong Standard, October 15 1999.
1. Which type of international business method did CLP use to

bid for the Tasmania cable project?
2. Suggest two reasons why CLP concentrates its effort to

expand in Asia only and not around the world.
UNIT 1 27
Summary
This completes the third section of Unit 1. In this lesson you have
been introduced to the various choices available in conducting
international business, comprising of international trade, licensing,
franchising, joint ventures, acquisitions of foreign firms, and
formation of foreign subsidiaries. By far, these are popular foreign
entry methods that are commonly used by MNCs. Of course, most
MNCs have more than one line of business. So it is quite common
that they engage in more than one of the above methods at the same
time. Most often, they need to deal with different foreign entry
methods based on project basis.
Reading
Please read the following article in WOU MyDigitalLibrary,

E-course reserves. This reading material is extracted from Madura
(2012) International Corporate Finance, 11th edn, South-Western
(pages 10 – 11).
Self-test 1.3
1. Toyota entered a joint venture agreement with General

Motors to produce cars in California. The plant produces
Chevrolet Prizms/Toyota Corollas. The joint venture is
intended to circumvent barriers that normally prevent foreign
competition for Toyota. What barrier in the US is Toyota
circumventing as a result of the joint venture?
2. Do you think the acquisition of a foreign firm or licensing

will result in greater growth for an MNC? Which alternative
is likely to have more risk?
3. Explain why MNCs such as Coca Cola and PepsiCo, Inc.,

still have numerous opportunities for international expansion.
Feedback
Activity 1.3
1. It is a joint venture.
2. CLP is more familiar with the Asian business environment

and at the same time there are a lot of opportunities in
deregulating electricity markets in Asia.
UNIT 1 29
1.4 Foreign Exchange Rate Quotations

Objectives
1. Interpret foreign exchange rate quotations.
2. Calculate cross exchange rates and forward premiums or discounts.
3. Discuss and interpret the meaning of exchange rate equilibrium.
4. Calculate the profit from speculation on anticipated exchange rate changes.
Introduction
One of the key factors in international financial management is the foreign
exchange rate. In this section of the unit, we will discuss some of the ways in
which the exchange rate can affect international business. When an exchange
rate changes, everything else changes (e.g., foreign currency account receivables,
foreign currency account payables). Therefore, the very basic thing to do is to read
the exchange rate quotations and be able to do some calculations. An exchange
rate is essentially the price of a currency in terms of other currency. You can refer
to the ‘Business’ section of the maybank2u.com.my for a good example of an
exchange rate table.
Currency quotations in Malaysia

As one of the top foreign currency dealers in Malaysia, Maybank, and the other
major commercial banks in Malaysia (including Public Bank, CIMB, and etc.)
report spot prices for over 20 currency pairs of foreign exchange transactions every
working day. The prices quoted serve the purposes of over-the-counter (OTC)
transactions, spot contracts, forward exchange contracts, foreign currency notes
and currency options.
The OTC rate is for telegraphic transfers, demand drafts and currency notes
through branch networking. The spot contract rate is for transaction with delivery
two trading days from the date of transaction. For example, a contract signed on
Monday will settle on Wednesday.
A forward exchange contract is an agreement to buy or sell foreign currency at a

future date (more than two trading days) at a predetermined price. The forward
rate can be either at premium or at discount over the spot rate.
The rate for foreign currency notes is the rate offer for currency dealing at the
bank branch networking. This means that we can take our cash ($) to exchange for
other currencies in a bank ‘right on the spot’.
Last but not least, a currency option contract is an agreement allowing the buyer
(holder) with the right, but not obligation, to buy or sell foreign currency at a
predetermined rate on a specific future date.
The forward contracts and the option contracts provide a way to hedge and
manage against uncertain future currencies exposure, especially in international
trade. These contracts are known as the derivative contracts as their value
is“derived”from the foreign currencies. Except for the rates quoted for derivative
contracts, all the other rates can be referred as the spot rates.
Direct quotation
A direct quotation represents the value of a foreign currency in local currency.
Or the quotation represents the number of dollars per unit of foreign currency.
Table 1.1 reports the Maybank online exchange rate table, updated in 23 January
2009. All the rates quoted are against the Malaysian ringgit.
Now you are going to learn how to read foreign exchange quote. Table 1.1 gives
a terminology of buying and selling quote. It is also known as bid and offer
quote. Always remember that the bid or buying rate is always lower than the
offer or selling rate from the bank’s perspective.
Before we proceed to explain the quotation rate, I would like to introduce the
concept of price taker and price maker. A price maker is a party that quotes a
price, for example, the bank and money changer. A price taker is a party that
accepts the price, for example, the customer of the bank.
Table 1.1 is provided by Maybank which is the price maker and the customer
of the bank is the price taker. So we must look from the perspective of the price
maker which is Maybank. If you wish to buy 1 US dollar, Maybank will quote
you the higher price which is RM3.647. That means as a customer, you will
have to pay RM3.647 for every US dollar you intend to purchase. Now suppose
you just came back from holidays in US and you want some of your US dollar
currency notes to converted to RM at Maybank. Maybank will pay you (or buy
from you) RM3.549 for every US dollar you sell. If an exporter is remitting his
US dollar export earnings back to Malaysia, the rate used is RM3.582 (TT rate) or
if someone is sending back US dollar denominated cheque or bank draft, the rate
quoted shall be RM3.572. The bid-offer or buy-sell difference is called the spread.
The spread is actually the bank’s profit from buying and selling of currency.
So to recap what we have learnt so far, for every dollar we sell, we receive RM3.54
(currency notes quotation). However, this is not a direct quotation. We need to do
a simple calculation to get a direct quotation, for example $1/RM3.54 = $0.2825.
From the RM perspective, we can exchange every RM for $0.2825. The direct
quotation of the exchange rate for Malaysian ringgit is written as $0.2825/RM.
UNIT 1 31
Indirect quotation
Indirect quotation is the opposite of direct quotation. You represent exchange
rate as the amount of foreign currency per unit of $. In the above example,
RM3.5490/$ is an indirect quotation for the RM exchange rate. We will
immediately know that for every dollar sold, we will receive RM3.5490.
Currency Notes
Selling Buying Buying
Currency
TT/OD TT OD
Selling Buying
1 US Dollar 3.6470 3.5820 3.5720 3.6610 3.5490

1 Australian Dollar 2.4140 2.3090 2.2930 2.5020 2.2970
1 Brunei Dollar 2.4380 2.3780 2.3700 2.4630 2.3600
1 Canadian Dollar 2.9170 2.8460 2.8340 3.0220 2.8240
1 Euro 4.7520 4.6370 4.6170 4.8170 4.5780
1 New Zealand Dollar 1.9510 1.8640 1.8480 2.0520 1.8550
1 Papua N Guinea Kina 1.5020 1.2580 1.2420 NA NA
1 Singapore Dollar 2.4375 2.3780 2.3700 2.4630 2.3600
1 Sterling Pound 5.0670 4.9440 4.9240 5.4770 4.9060
1 Swiss Franc 3.1670 3.0900 3.0750 3.2240 3.0660
100 Arab Emirates Dirham 101.070 95.7300 95.5300 100.790 96.1900
100 Bangladesh Taka 5.5200 5.2000 5.0000 NA NA
100 Chinese Renminbi NA NA NA NA NA
100 Danish Krone 65.6500 60.3400 60.1400 NA NA
100 Hongkong Dollar 47.8500 45.3200 45.1200 47.9000 45.0800
100 Indian Rupee 7.7400 7.1100 6.9100 NA NA
100 Indonesian Rupiah 0.0341 0.0290 0.0240 0.0345 0.0290
100 Japanese Yen 4.1030 4.0050 3.9950 4.1300 3.9700
100 New Taiwan Dollar NA NA NA 11.4400 10.0700
100 Norwegian Krone 54.2400 49.8400 49.6400 64.1300 49.8600
100 Pakistan Rupee 4.6900 4.3700 4.1700 5.0300 4.2300
100 Philippine Peso 7.8800 7.3900 7.1900 8.1300 7.3900
100 Qatar Riyal 101.740 96.7800 96.5800 NA NA
Currency Notes
Selling Buying Buying
Currency
TT/OD TT OD
Selling Buying
100 Saudi Riyal 98.790 93.970 93.770 98.720 93.990

100 South Africa Rand 37.4800 34.4900 34.2900 40.6400 34.7700
100 Sri Lanka Rupee 3.3100 3.0400 2.8400 3.7100 2.9400
100 Swedish Krona 45.9300 41.7700 41.5700 NA NA
100 Thai Baht 11.2200 9.5000 9.3000 11.4100 9.6400
Table 1.1 Example of exchange rate quotations

Source: Last update: 23 January 2009, Maybank (rates quoted against Malaysian ringgit),
from http://www.maybank2u.com.my/business/treasury/foreign_exchange.shtml
Bid/ask spread
When a bank (or currency exchange shop) buys or sells foreign currencies, it uses
slightly different exchange rates for the same currency. A bid rate (or the buy rate)
for a foreign currency is always less than the ask rate (or the sell rate) for a foreign
currency. The difference is called bid/ask spread.
Mathematically,
bid/ask spread = (ask rate − bid rate)/ask rate
For example, for the British pound (£), if the bid rate is $1.97/£ and the ask rate is
$2.05/£, the bid/ask spread = (2.05 − 1.97)/2.05 = 0.039 or 3.9%.
Another example, quoting the US dollar rate for currency notes from Table 1.1,
where the selling (ask) rate for US dollar is RM3.6610 and buying (bid) rate is
RM3.5490:
the bid/ask spread = (3.6610 − 3.5490)/3.6610 = 0.0306 or 3.06%.
The foreign exchange market allows currencies to be exchanged in order to

facilitate international trade or financial transactions. The following reading
enables you to be familiar with the basic operations of the foreign exchange
market.
UNIT 1 33
Activity 1.4
Do the following calculations.
1. If a dollar (US dollar) is worth 1.367 Singapore dollars, what

is the US dollar value of a Singapore dollar?
2. A commercial bank quotes a bid rate of $0.958/A$ and an

ask rate of $0.974/A$. What is the bid/ask spread of the
Australian dollar?
Cross exchange rate calculations

Cross exchange rate reflects the amount of one foreign currency per unit of
another foreign currency. Usually banks will not quote exchange rates in terms of
all other currencies in the world. They only quote major exchange rates for those
currencies that are used commonly in the country. So, how would we know the
exchange rate for those foreign currencies that are not quoted?
For example, if a Malaysian company is doing business with a Korean company,

and the Korean company is not receiving any other foreign currencies for
payment, except for their national currency, i.e., Korean won, then the Malaysian
company should be concerned about the exchange rate between the Malaysian
ringgit (RM) and the Korean won (KW).
We can calculate the cross exchange rate between RM and KW from RM/$ and
KW/$. Let us use the following exchange rates to illustrate the cross exchange rate
between the two currencies:
We have:
RM and US$ exchange rate: 3.6470, i.e., RM3.6470/$
The exchange rate of Korean won and US$ is KW1409.6373/$
If we want to find out how many Korean won you will receive with one Malaysian
ringgit, we use:
(KW1409.6373/$) ÷ (RM3.6470/$) = KW386.5197/RM
Please be aware that the $ signs offset each other in the calculation, the RM sign
remains in the denominator, and the KW sign is in the numerator of the calculation:
KW/$ ÷ RM/$ = KW/RM

Forward premiums and discounts calculations

A spot rate is the exchange rate of purchasing or selling currencies for immediate
delivery, usually within 2 working days. A forward rate, on the other hand, is the
exchange rate of purchasing or selling currencies in future periods at a rate agreed
upon today. Two parties in a forward contract agree on a forward rate. Usually
a bank serves as a dealer to sell or buy foreign currency in a forward contract. A
forward contract can hedge future receivables or payables in foreign currencies to
insulate the firm from exchange rate risk. We shall discuss hedging in Unit 2.
For example, if the forward rate quoted for a 30-day forward contract for US
dollar is RM3.6345/$. This means that if you sign up the contract to purchase
1 million US dollars, you will receive the 1 million US dollars after 30 days.
The price that you need to pay for that is RM3.6345 × 1 million US dollars =
RM3.6345 million. Note that the current spot exchange rate quoted in Table 1.1
is RM3.647/$. The positive and negative differences between the forward rate and
the spot rate are called forward premiums and discounts, respectively, which can
be calculated using the following formula:
Forward discount or premium (in annual percentage)
= [(forward rate − spot rate)/spot rate] × 360/ff contract day
where ff contract day = the forward contract day.
(Note: all the exchange rates are in direct quotations, i.e., $ per unit of foreign
currency).
If the result is a positive number, we call it a forward premium. If the result is a

negative number, we call it a forward discount. Let us illustrate the calculations
using two simple examples.
Example 1
Using the above information, where the 30-day forward rate for US dollar is
RM3.6345/$ and the spot rate is RM3.647/$, what is the forward premium or
discount for the US dollar?
Forward premium or discount

= [(RM3.6345 − RM3.647) / RM3.647] × 360/30
= 4. 131% (discount)
UNIT 1 35
Example 2
If the 120-day forward rate for US dollar is RM3.701/$ and the spot rate is
RM3.647/$, what is the forward premium or discount for the US dollar?
Forward premium or discount

= [(RM3.701 − RM3.647)/RM3.647] × 360/120
= 4.442% (premium)
Forward premiums and discounts interpretation

If the result is a forward premium and other factors remain the same, the exchange
market expects the foreign currency will be stronger. In other words, the foreign
currency is going to appreciate, i.e., for every foreign currency, you will get more
dollars at a future date.
If the result is a forward discount and other factors remain the same, the exchange
market expects the foreign currency will be weaker. In other words, the foreign
currency is going to depreciate, i.e., for every foreign currency, you will get fewer
dollars at a future date.
This is a good time for me to introduce you to the concept of forward

premium or discount. Forward exchange rates are one of the popular
exchange rate tools in the foreign exchange market. Besides, knowledge of
forward exchange rates is the foundation for the exchange rate determination
theories in Unit 2.
Cross exchange rates and forward premiums and discounts

Cross exchange rates and forward premiums and discounts are important to an
MNC when the corporation calculates the value of its international business. As
an MNC receives and pays in one or more foreign currencies, the corporation
has to convert its receipts and expenses from these different currencies into
domestic currency. With the value of its international businesses in one currency,
the corporation is able to aggregate and compare all its international business
transactions. In addition, forward premiums and discounts are important elements
when an MNC contracts with banks or other financial institutions in buying and
selling future currencies. These are called forward contracts.
The calculation of forward premiums and discounts from forward contracts

provides information on the market expectation about the currency of
interest. Given the exposure of MNC to exchange rate risk, it is imperative
to have knowledge of the workings of these forward contracts and the foreign
exchanges market expectation. The following sections exhibit the calculation
of cross exchange rates and that of forward premiums and discounts. You need
to comprehend these basic calculations before you can follow more complex
discussions in other units.
In addition, http://www.bloomberg.com provides daily exchange rate for currencies.

Go to this website and get yourself familiarised with the quotation. In addition, this
website http://biz.yahoo.com/topic/currency/ provides current news, market wrap
up and future forecast on exchange rate (technical analysis).
Activity 1.5
1. Given that:
British pound (£)

Spot rate US$1.9796/£
1-month forward US$1.9790/£
Please calculate the 1-month, 3-month and 6-month forward

premium or discount for the British pound (£) (there are a
total of three answers). Briefly state whether the pound has a
forward premium or discount.
2. Briefly interpret your findings in (1).
The exchange rate equilibrium

It is time for you to study several concepts related to the determination of exchange
rate in the foreign exchange system. The equilibrium exchange rate between two
currencies at any point in time is based on the demand and supply conditions.
Changes in demand for a currency and supply of a currency for sale will affect the
equilibrium exchange rate. You will learn from this section how equilibrium exchange
rates are determined and understand the underlying factors that contribute to the
changes in equilibrium exchange rates.
Measuring exchange rate movements

Primarily, there are two types of exchange rate movement: appreciation (up) or
depreciation (down). By definition, appreciation (depreciation) means an increase (a
decrease) in currency value. However, we need to be careful. We need to remember
that every exchange rate quotation in this course is a direct quotation (i.e., always
dollars per unit of foreign currency).
UNIT 1 37
For instance, if the ringgit and dollar exchange rate is currently at RM3.5500/$,
then a 1% appreciation of the dollar means an increase in the value of dollars
relative to ringgit, i.e., the exchange rate moves from RM3.5500/$, to RM3.5855/$,
or more specifically the [3.55*(1+0.01)]. Be careful that, in this case, the ringgit
has depreciated relative to the dollar. Hence, when we talk about appreciation or
depreciation, we need to specify that a currency appreciates relative to another
currency and we need to be sure that we are talking about a direct quotation of
exchange rate in the involved currency (in this case it is the pound).
Simply put, the percentage change in the value of a foreign currency (e.g., US
dollars, $) relative to ringgit is computed as:
Percentage change in foreign currency value, ∆St = (St − St − 1)/St − 1
where
St = the spot exchange rate of the foreign currency in direct quotation (e.g., RM/$)
at time t;
St − 1 = the spot exchange rate of the foreign currency in direct quotation (e.g.,
RM/$) at time t − 1.
If we use the pound and dollar exchange rate as an example, when there is a positive
percentage change (i.e., St > 0), then the pound has an appreciation relative to the
dollar or vice versa.
Demand for a currency

The basic concepts of currency demand are the same as your demand and supply
model in microeconomics. The only modification here is that instead of talking about
the demand and supply of oranges, we talk about the demand and supply of ringgit.
Or we simply treat a foreign currency, in this case the ringgit, as a commodity in
the demand and supply discussion. The exchange rate is the same as the ‘price’ of
the foreign currency in terms of the ringgit.
The demand for ringgit in the foreign exchange market shows the varying
quantity of ringgit that would be purchased (by market participants) given
various ‘price’ or exchange rates of the ringgit. The demand schedule can be
represented as a downward sloping curve, just like a normal demand curve, as
shown in Figure 1.7 in the following. Let us refer to Table 1.1 for the Malaysian
ringgit (RM) and US dollar ($) exchange rate as an example. The exchange rate as
reported is RM3.6470/$. To illustrate the demand curve, we need to convert this
rate into a direct quotation, i.e., $0.2742/RM.
In Figure 1.7, when the price of foreign currency ($) is 0.2742, the quantity of
RM demanded is 5 billion units of ringgit. The demand forces on the ringgit
are mainly from foreign importers (or tourists) who need ringgit to pay for their
buying of Malaysian goods. Now if the price of dollar has gone up to $0.2800/
RM, the demand on ringgit is only 4 billion. This is because the foreign buyers
need to pay more units of their currency to obtain a unit of ringgit in purchasing
the Malaysian goods. Assuming that the income of the foreigners is fixed, then the
total units of their purchase on Malaysian goods will drop, and hence the demand
on ringgit will drop.
Price of RM in terms
of one US dollar
$0.2800/RM
$0.2742/RM
4 billion 5 billion Quantity of RM

demanded
Figure 1.7 The demand for currency
Supply of a currency
For the supply of ringgit, the same logic applies. The supply of ringgit in the
foreign exchange market shows the varying quantity of ringgit that would be
offered for sale given various exchange rates of the ringgit. Again, we can draw an
upward sloping curve to represent the supply of ringgit in the foreign exchange
market, as illustrated in Figure 1.8 in the following.
From Figure 1.7, the quantity of RM demanded is 5 billion units of ringgit when
the price of foreign currency ($) is 0.2742. From Figure 1.8, the quantity of
RM supplied is 4 billion units of ringgit when the price of dollar ($) is 0.2742.
This shows that the market is not in equilibrium for both the level of exchange
rates. The supply forces on ringgit are mainly from local importers (or local
tourists) who need US dollar to pay for their buying of goods and services from
the US. Now if the price of dollar has gone up to $0.2800/RM, the supply on
ringgit is 5 billion. This is because the Malaysian buyers can obtain more units
of the US dollar for a unit of ringgit paid. In other words, with the same income,
Malaysian buyers now can afford to purchase more units of foreign goods, and
hence the supply on ringgit will increase.
UNIT 1 39
of one US dollar
$0.2800/RM
$0.2742/RM

demanded
Figure 1.8 The supply for currency
The exchange rate equilibrium

When we put together the demand and supply of ringgit, we have an equilibrium
exchange rate for the ringgit and an equilibrium quantity of ringgit. Figure 1.9
in the following exhibits the exchange rate equilibrium: the supply schedule of
Malaysian ringgit for sale in the exchange market is upward sloping while the
demand schedule is downward sloping.
In Figure 1.9, when the price of dollar ($) is $0.2800/RM, the quantity of RM
demanded is only 4 billion units of ringgit but the quantity of RM supplied is 5
billion units of ringgit. In this case, there is an oversupply of ringgit in the market.
On the other hand, when the price of dollar ($) is $0.2742/RM, the quantity of
RM demanded is 5 billion units of ringgit but the quantity of RM supplied is
only 4 billion units of ringgit. In this case, there is an overdemand of ringgit in
the market. Apparently, in both the cases, the exchange rates are not clearing the
market. The two levels of exchange rates are not the equilibrium exchange rate.
Instead, both schedules intersect at $0.2750/RM. At this rate, the demand and
supply for Malaysian ringgit are both 4.5 billion; the market is clear. There is no
excess demand nor did excess supply occur. Therefore the equilibrium exchange
rate is at $0.2750/RM.
of one US dollar
$0.2800/RM
$0.2750/RM
$0.2742/RM

4.5 billion demanded
Figure 1.9 The equilibrium of demand and supply of currency
This equilibrium concept would be useful to predict a general direction of the

exchange rate movement (i.e., appreciation or depreciation). The following graph
illustrates an appreciation of Malaysian ringgit. For example, if the economy in
Malaysia slows down, then the demand for goods and services from a foreign
country (the US) will drop. The Malaysian people would buy fewer foreign goods
(including US goods), and the Malaysian importers would not need to sell as
many ringgit as before in the foreign exchange market to convert to dollars to pay
for US imports. Therefore, the supply of ringgit in the foreign exchange market
will drop if the demand for ringgit does not change, as other countries do not
necessarily buy less from Malaysia.
As illustrated in Figure 1.10, only the supply curve of the ringgit will move to
the left (a decrease in the supply of ringgit), while the demand curve does not
change. Accordingly, the ringgit will have a lower dollar rate in direct quotation
(or higher exchange rate in the indirect quotation), say $0.285/RM, and a smaller
amount, say only 3.8 billion of ringgit will change hands in the foreign exchange
market.
UNIT 1 41
of one US dollar
$0.2800/RM
$0.2750/RM
3.8 billion 4.5 billion Quantity of RM

demanded
Figure 1.10 An appreciation of Malaysian ringgit
Factors that influence equilibrium exchange rate

There are many forces in the market that may affect the equilibrium exchange
rate. Here, we list five main factors that determine the equilibrium exchange rate.
They are:
1. Relative inflation rate
2. Relative interest rate
3. Relative income level
4. Government controls
5. Market expectations
Let us continue to assume that Malaysia is the home country and the US represents
the foreign country. The exchange rate is still in direct quotation, i.e., the units
of dollars per one ringgit ($/RM). In the following table, we summarise how the
above five factors influence the equilibrium exchange rate:
Examples of
Factors Results
what happens
1 relative inflation rate US has sudden US goods are more expensive;
inflation; Malaysia US has fewer exports to Malaysia
price is stable. but will buy more imports from
Malaysia; demand for $ drops;
supply for $ increases; exchange
rate drops or $ depreciates
2 relative interest rate Malaysia interest US and Malaysia investors find
rate rises relative investing in Malaysia more
to US attractive than US; demand for
$ drops; supply for $ increases;
exchange rate drops or $
depreciates
3 relative income level Malaysia income Malaysia buys more US goods;
level rises while need $ to pay for the US goods;
US income level is demand for $ increases while
stable supply is unchanged; exchange
rate rises or $ appreciates
4 government controls Can have different Results vary
types of control
5 market expectations Market expects $ Speculators or investors buy $
to appreciate to make profits; demand for $
rises; exchange rate rises or $
appreciates
Table 1.2 Factors that influence equilibrium exchange rate
Reading

(pages 107 – 111).
UNIT 1 43
Activity 1.6
Answer the following questions.
1. Assume the spot rate of the British pound is $1.93/£ today.

The expected spot rate one year from today is assumed to be
$1.86/£. What percentage depreciation does this reflect?
2. Assume the Japanese government relaxes its controls on

imports by Japanese companies. Other things being equal,
how would this affect (a) the US demand for Japanese yen;
(b) the supply of yen for sale in the foreign exchange market;
and (c) the equilibrium value of the yen exchange rate?
Speculating on anticipated exchange rate changes

The immediate application of studying the underlying factors that affect
equilibrium exchange rates is making profits by investors in the foreign exchange
market. In this section, you will learn the basic steps to profit from exchange rate
speculations.
Calculating the profit from speculating on anticipated exchange rate

changes
Many international banks have their own foreign exchange departments. The manager
of the foreign exchange department is usually its principal foreign exchange dealer.
Based on his or her knowledge and anticipation of economic and financial events, a
foreign exchange dealer often speculates on the exchange rate movement of a currency.
He or she may take a position (to sell or buy a currency) in the foreign exchange
market with the intention of making a profit for his or her bank. We take some
time here to illustrate how a foreign exchange dealer (or anyone) can speculate on
anticipated exchange rate changes.
Let us illustrate with an example. Assume the following information:
• XYZ bank expects the New Zealand dollar (NZ$) to appreciate from
$0.75/NZ$ to $0.77/NZ$ in 30 days.
• XYZ bank is able to borrow $20 million on a short-term basis from other
banks.
• The annual lending and borrowing rates are given as:
Currency Lending rates Borrowing rates
US dollars 6.72% 7.20%

NZ dollars 6.48% 6.96%
(Note: it is quite natural that the borrowing rates are always larger than the
lending rates)
Given the information above, XYZ bank can take positions in New Zealand
dollars and speculate on the anticipated appreciation of New Zealand dollars.
Please note that if the foreign exchange dealer expected the New Zealand
dollar to appreciate, then the dealer would try to buy New Zealand dollars
with dollars now and resell the New Zealand dollars 30 days later to capitalise
the profit. Here are the steps:
1. Borrow $20 million.
2. Convert $20 million to New Zealand dollars using the spot exchange rate
of $0.75/NZ$; receive NZ$26.67 million ($20 million ÷ $0.50/NZ$).
3. Lend the NZ$40 million for 30 days at 6.48% (annual rate); after 30
days, the principal plus interest would be NZ$26.67 million × (1 +
6.48% × 30/360) = NZ$26.68 million.
4. Convert the NZ$26.68 million back to dollars at the anticipated

exchange rate of $0.77/NZ$; the dollar amount would be NZ$26.68
million × $0.77/NZ$ = $20.5436 million.
5. Repay the $26.67 million loan; principal plus interest would be $20
million × (1 + 7.2% × 30/360) = $20.12 million.
6. Calculate the profit (in dollars) = $20.5436 million − $20.12 million =

$0.4236 million or $423,600.
Obviously, the above procedure is not a sure bet. It depends on:
• whether the exchange rate forecast is correct or not;
• the borrowing rate of the dollar and the lending rate of the New Zealand
dollar;
• the borrowing capacity of the XYZ bank.

UNIT 1 45
Practically, a borrowing period of 30 days is way too long. Foreign exchange dealers
usually only take the same day's or at most a few days' positions when they speculate
on foreign currencies.
The following is another example. Assume the following information:
• The Chinese Bank expects the New Zealand dollar (NZ$) to depreciate with
respect to the Hong Kong dollar from HK$5.912/NZ$ to HK$5.6755/NZ$
in 14 days.
• The Chinese Bank is able to borrow HK$20 million or NZ$3.38 million

on a short-term basis from other banks.
• The annual lending and borrowing rates are given as:
Currency Lending rates Borrowing rates
Hong Kong dollars 8.00% 9.00%

NZ dollars 9.00% 10.00%
Given the information above, the Chinese Bank can take positions in Hong
Kong dollars and speculate on the anticipated appreciation of the Hong Kong
dollar (and also the depreciation of the New Zealand dollar). Please note that
if the foreign exchange dealer expects the New Zealand dollar to depreciate,
then the dealer will try to buy Hong Kong dollars with New Zealand dollars
now and resell the New Zealand dollars 14 days later to capitalise the profit.
Here are the steps:
1. Borrow NZ$3.38 million at 10%.
2. Convert NZ$3.38 million to Hong Kong dollars using the spot

exchange rate of HK$5.912/NZ$; receive HK$19.98 million (NZ$3.38
million × $5.912/NZ$).
3. Lend the HK$19.98 million for 14 days at 8.00% (annual rate); after
14 days, the principal plus interest would be HK$19.98 million × (1 +
8% × 14/360) = HK$20.0419 million.
4. Convert the HK$20.0419 million back to New Zealand dollars at the

anticipated exchange rate of HK$5.6755/NZ$; the NZ$ amount would
be HK$20.0419 million ÷ HK$5.6755/NZ$ = NZ$3.5313 million.
5. Repay the NZ$3.38 million loan; the principal plus interest would be
NZ$3.38 million × (1 + 10% × 14/360) = NZ$3.3932 million.
6. Calculate the profit (in New Zealand dollars) = NZ$3.5313 million −

NZ$3.3932 million = NZ$0.1381 million or NZ$138,100.
Summary
This completes the fourth section of Unit 1. By now, you

should be clear on how to read the various foreign exchange rate
quotations, including both direct and indirect quotations for spot
and forward contracts, and bank quotations with bid/ask spread.
Also, you should be able to calculate cross exchange rates, as
well as forward premiums or discounts from a forward contract.
This section also explains how exchange rate achieves market
equilibrium by the demand and supply forces behind the market.
As the equilibrium rate is the rate quoted for currencies of two
countries, it is always driven by major macroeconomic factors in
the two countries, including the relative inflation rate, relative
interest rate, relative income level, government controls and market
expectations. As the market is not always in equilibrium, there
will be always speculative trading on currencies. Calculation of
the profit from speculating on anticipated exchange rate changes
is also illustrated.
Reading

(pages 116 – 119).
Self-test 1.4
1. Citibank’s bid price for Canadian dollars is $0.7938 and its

asking price is $0.81. What is the bid/ask percentage spread?
2. Assume Poland’s currency (the zloty) is worth $.17 and the

Japanese yen is worth $.008. What is the cross rate of the
zloty with respect to yen? That is, how many yen equals a
zloty?
3. If the Asian countries experience a decline in economic

growth (and experience a decline in inflation and interest rates
as a result), how will their currency values (relative to the U.S.
dollar) be affected?
UNIT 1 47
4. Assume the spot rate of the British pound is $1.73. The

expected spot rate one year from now is assumed to be $1.66.
What percentage depreciation does this reflect?
5. Compute the forward discount or premium for the Mexican

peso whose 90 day forward rate is $.102 and spot rate is
$.10. State whether your answer is a discount or premium.
Suggested answers to activities
Feedback
Activity 1.4
1. $/S$ = 1/1.367 = $0.7315/S$
2. The bid/ask spread = (0.974 − 0.958)/0.974 = 0.0164 or

1.64%.
Activity 1.5
1.
Currency 1 month 3 month 6 month
£ [(1.9790 − [(1.9785 − [(1.9787 −

1.9796)/1.9796] 1.9796)/1.9796] 1.9796)/1.9796]
(360/30) × 100% = (360/90) × 100% = (360/180) × 100% =
−0.36% −0.24% −0.10%
The pound has a forward discount across three different

maturities.
2. The forward discount of the pound suggests that the pound

spot rate is expected to depreciate in the foreign exchange
market. In addition, the forward discount is smaller as the
maturity is longer. This suggests that the degree of depreciation
of the pound is less than six months from today. The forward
premium of the pound suggests that the pound spot rate is
expected to appreciate in the foreign exchange market. In
addition, the forward premium is stable (less than 0.4%)

across different maturities. This suggests that the appreciation
expectation will not change in the next six months.
Activity 1.6
1. Percentage of depreciation = (1.86 − 1.93)/1.93 × 100% =

−3.63% or it is expected to depreciate 3.63%
2. When the Japanese government relaxes its controls on imports

by Japanese companies, there will be an increase in imports
into Japan from all over the world. Then Japanese companies
need to sell yen in the foreign exchange market to exchange
to other currencies to pay for the imports (or the Japanese
companies pay in yen but the trade partners will dump the yen
in the foreign exchange market to exchange to their respective
home currencies. The effect is the same). Accordingly, other
things being equal, there will be an increase in the supply of
yen for sale in the exchange market. Please remember that
the above impact does not affect the US companies in terms
of their purchase of yen in the exchange market. The answers
to the questions:
a. There is no change in the US demand for yen.
b. There is an increase in the supply of yen in the exchange

market.
c. The value of yen will drop since the demand curve is the
same and an increase in the supply of yen will lead to a lower
equilibrium value of yen. That is, the yen will depreciate in
the exchange market.
UNIT 1 49
1.5 The History of Different Exchange

Rate Systems
Objectives
1. Discuss the history of different exchange rate systems.
2. Compare and contrast the different exchange regimes in the present day.
3. Compare and contrast the fixed and flexible exchange rate regime.
4. Discuss critically the mechanism of the Euro currency.
Introduction
After spending much time in learning all the exchange rate calculations, the
operations of and the dynamics of the foreign exchange markets, you might raise
questions: What is the institution of foreign exchange market? Who set it up? And
when was it set up? What have been the changes over time since it was set up?
What are the characteristics of the different systems? These are questions related
to the fundamentals of the foreign exchange market as an institution. The answers
to these questions help us understand why and how the present foreign exchange
market has arrived at its present state and operates as it does. This section traces
the history of the foreign exchange market.
Exchange rate systems can be classified as fixed rate, freely floating, managed
float, and pegged. In a fixed exchange rate system, exchange rates are either
held constant or allowed to fluctuate only within very narrow ranges. In a freely
floating exchange rate system, exchange rate values are determined by market
demand and supply. In a managed floating system, exchange rates are subject
to government intervention. Exchange rates move but government intervention
can step in any time to counter any moves. In a pegged exchange rate system,
an exchange rate is pegged to a currency (or a basket of currencies). The value of
the currency is linked to another currency. In this section, you will learn a brief
history of various exchange rate systems, from the days of classical gold standard
to the present time of flexible exchange regimes.
The pre-classic exchange regime (pre 1870)

International trade has a long history in line with the modern history of
mankind. Gold and other commodities of value, such as silver, have been used
as the medium of exchange to facilitate the transfer of goods and services across
borders. The history of gold can be traced since the ages of the pharaohs (3000
B.C.) where gold has been used not only as a medium of exchange, but also as
a unit of account and a store of value for their assets. In the coinage era, gold
coins have been established as the common currency in the Greeks and Romans
empires. In the mercantile era, up to the nineteenth century, so-called the era of
bimetallism, both gold and silver has been accepted as the system of currency. The
era of bimetallism continue until the early 1900s, when World War I break out.
After that, a more formalised system of international settlement of trade balances
is needed. However, in the modern era of economies, the international exchange
rate system, or more closely, the international monetary system, has experienced
a variety of international agreements. After the early 1970s, the flexible exchange
rate regime has dominated the scene of international monetary system until the
present day.
Classical gold standard (1870 –1914)

In the early arrangement of gold standard, the rule of the game is that every
country sets a par value for its currency in terms of gold. Essentially, every currency
was pegged with gold, and the world had a fixed exchange rate system. This era
later came to be known as the classical gold standard. The gold standard as an
international monetary system was recognised widely in Western Europe in the
1870s. For the United States, the standard was only officially adopted in 1879.
The classical gold standard was clear and simple. To illustrate this point, let us
assume one ounce of gold was worth $36 in New York and the same ounce of
gold was selling at £18 in London. This implied that the exchange rate between
dollars and pounds was $2/£ because one could buy one ounce of gold for £18
in London and take the gold to New York and sell the same ounce of gold for
$36. The following equations summarises the case:
New York : $36 = 1 ounce of gold
London : £18 = 1 ounce of gold
So, $36 = 1 ounce of gold = £18
exchange rate is : $2 = £1
The exchange rate is determined by the relative gold contents of the two countries.
If there was an imbalance between dollars and pounds, there would be an
adjustment through gold outflows or inflows. Hence, you might remember a lot
of old movies describing pirates trying to attack gold shipment over the Atlantic
Ocean. During this time period, there was indeed a lot of physical transportation
UNIT 1 51
of gold among countries. Because of stable exchange rates among countries, there
was no exchange risk. The governments that follow the gold standard agreed to
buy or sell gold on demand with all parties at the official fixed parity rate. That
is, importers and exporters could easily determine their payments and receipts
in international trade. As a result, the world enjoyed relatively free trade and
unrestricted international capital movement.
The gold standard lasted until the outbreak of World War I. International trade
and free movement of gold was interrupted. As a result, many countries suspended
the system of gold standard during the mid 1910s.
Interwar period (1915 –1943)

This was the World War I and II period. During the late 1910s to early 1920s,
currencies were allowed to fluctuate over fairly wide ranges in terms of gold and
its exchange rates with other countries. A lot of changes in exchange rates were
not warranted by real economic factors.
In theory, exchange rate should only have moderate changes as it is determined

by supply and demand arises from fairly stable international trade. In this era,
some countries (e.g., Germany) considered that ‘import is bad and export is good’.
Hence, there were a lot of trade restrictions (tariffs and quotas) to restrict imports.
Along the same logic, if a country had its currency devaluated, it could promote
exports and limit imports. The above trade restriction and currency devaluation
policies only worked if other countries did not practice the same strategy. However,
this was not the case. We saw countries having competitive devaluation and
enormous trade restrictions. Therefore, the volume of trade decreased in half
(compared with the gold standard era) and exchange rates fluctuated.
Moreover, the emergence of currency speculators made things worse. Weak

currencies were sold short, leading to sharp drop in values that did not tally with
their economic fundamentals. The reverse happens with strong currencies. As a
result of the competitive devaluations and the speculative activities, world trade
volume fell in the 1920s, leading to the advent of the Great Depression in the
early 1930s.
Prior to World War I, the US dollar was $20.67 per ounce of gold. When the US
dollar was devalued to $35 per ounce of gold in 1934, the United States adopted
a modified gold standard, where the US Treasury announced that they do not
trade gold with private citizens; they traded only with foreign central banks.
During World War II and the chaotic period after the war time, many of the
main trading currencies lost their values, and some even lost their international
convertibility into other currencies. The US dollar was the only major trading
currency left to remain internationally convertible.
Gold-exchange standard or the Bretton Wood system (1944 –1973)

World War II ended in 1944. After the war, many countries learnt from their
mistakes of trade restrictions and competitive devaluations during the interwar
period. In July 1944, representatives of 44 countries, headed by the Allied Powers
met in Bretton Wood in New Hampshire in the US in order to discuss trade
issues and create a new postwar international monetary system. They agreed to
sign the Bretton Wood Agreement to establish a US dollar based international
monetary system, and also agreed to set up 2 international monetary institutions:
The International Monetary Fund (IMF) and the International Bank for
Reconstruction and Development (known as World Bank later).
The IMF was the key institution in developing the new international monetary
system until today. The main functions of the IMF were:
• It set up borrowing facilities for nations with a temporary balance of

payment difficulty.
• Each country fixed the value of its currency in terms of gold or dollars and
then kept its exchange rate within 1% of its par value. The par value could
change with the permission of the IMF.
• Only the US dollar remained convertible into gold at $35 per ounce price.
All other countries fixed its currency vis-à-vis the US dollar. In other
words, a dollar-based gold-exchange standard was established.
• Devaluation was not allowed to be used as a policy to gain trade

competitiveness. However, in the case where a currency became too weak
to defend, a devaluation of up to 10% was allowed without approval by
IMF.
• The balance of payments was adjusted with the flows of gold among central
banks.
• The Special Drawing Right (SDR) was created. SDR is an international

reserve asset designed to supplement existing foreign exchange reserves.
Members of IMF may settle their international trade transactions by
transferring the unit of account of their SDRs with IMF. SDR was initially
defined in terms of a fixed quantity of gold, but it has been redefined several
times after that. Currently, SDR is defined as the weighted average of four
major currencies, namely: the US dollar, the Euro, the Japanese yen and the
British pound.
The new international monetary arrangement under the Bretton Wood Agreement
performed very well over this period. World trade steadily increased and exchange
rates were stable. Nonetheless, widely diverging monetary and fiscal policies,
inflation differentials, and unexpected shocks in economic fundamentals has causes
the Bretton Wood system to collapse in the early 1970s.
UNIT 1 53
A managed floating exchange rate system (1973 –present)

As seen from the Bretton-Wood system, one of the major functions of the IMF
was to set up a gold-exchange standard for exchange rate arrangements. Each
country’s currency was backed up by gold and US dollars. There were several
unintended consequences of the gold-exchange standard, however:
• US dollars were used as an international reserve.
• The US felt that it could not devalue the dollar, otherwise the US might
wipe out the wealth of other countries.
• When the balance of payment deficits in the US built up, confidence in the
US dollar dropped around the world since other countries used US dollars
as their reserve to back up their own currencies.
• There was pressure for the US dollar to devalue. In the 1960s and 1970s, the
US government was fighting an expensive war in Vietnam. The government
was printing money to finance its war expenditure.
• There was massive transfer of capital away from the US in the early 1970s.
On August 15 1971, the US Government suspended the gold convertibility of

the dollar. Later on, the US and other countries met and signed the Smithsonian
agreement. Essentially, countries maintained fixed exchange rates among themselves
with a 2.25% upper and lower limit and the US dollar at the same time devalued
by 8.57%. However, capital outflow from the US continued (selling dollars and
converting dollars into other major currencies). The US dollar further devalued
another 10% in the next few months and the capital outflow from the US kept
on. In March 1973, US President Richard Nixon announced that US exchange
rates with all other currencies were free to float. The selling pressure on the dollar
stopped. That was the beginning of a floating exchange rate system.
Since March 1973, except for occasional central bank intervention, exchange rates
have been floating freely. We also called the system a managed floating exchange
rate system. Because of the floating exchange rate system, the exchange rate
may not be stable over time. Hence, it would be risky to engage in international
business. This is because MNCs cannot assure the amount of home currency
paying others (in foreign currencies) or receiving foreign currencies from others.
As a consequence, we need to study international financial management. Or to put
it simply, it was quite a simple job to manage international finance before 1973.
After 1973, it became a challenging job and that is one of the reasons why we
need to study this course!
The present currency regimes

The international monetary system today is composed of many types of currency
regimes. One special case of this pegged exchange rate system is a currency board
arrangement like the one in Hong Kong. Since 1983, Hong Kong has tied its
currency with the dollar (HK$7.8=$1). The Hong Kong Monetary Authority
(HKMA) uses the Hong Kong Reserve Fund to buy or sell US dollars in the
exchange market to support the target exchange rate of HK$7.8 = $1. For instance,
if there are more Hong Kong dollars offered to convert to dollars in the exchange
market, there will be a tendency for the Hong Kong dollar to depreciate (i.e., $1
will be exchanged for more than HK$7.8). In such a case, the HKMA intervenes
in the foreign exchange market to sell US dollars. Simply put, the HKMA uses
US dollars to buy Hong Kong dollars in the exchange market. In this case,
the pegged exchange rate of HK$7.8=$1 is preserved.
According to IMF, there are eight specific categories, which span the spectrum of
currency regimes from fully pegged to independently floating. The IMF classification
is based on each country’s actual, de facto, arrangement as identified by IMF
staff, which may differ from the de jure arrangement officially announced by the
country. The following table (adopted from IMF’s website) listed all the eight
IMF categories, with simple details:
Exchange rate regimes Description
1. Exchange arrangements The currency of another country circulates as the

with no separate legal sole legal tender. One such example is dollarisation,
tender or the member belongs to a monetary or currency
union in which the same legal tender is shared by
the members of the union, such as the Euro.
2. Currency board Explicitly and legislatively committed to fix to
arrangements a specified foreign currency, combined with
restrictions on the issuing authority to ensure
the fulfillment of its legal obligation. This implies
that domestic currency will be issued only against
foreign exchange and that it remains fully backed
by foreign assets.
3. Conventional fixed peg The country pegs its currency within margins of
arrangements ±1 percent or less vis-à-vis another currency; a
cooperative arrangement; or a basket of currencies,
where the basket is formed from the currencies
of major trading or financial partners and weights
reflect the geographical distribution of trade,
services, or capital flows. The currency composites
can also be standardised, as in the case of the SDR.
4. Pegged exchange rates The value of the currency is maintained within
within horizontal bands certain margins of fluctuation of more than ±1
percent around a fixed central rate or the margin
between the maximum and minimum value of the
exchange rate exceeds 2 percent. As in the case of
conventional fixed pegs, reference may be made to
a single currency, a cooperative arrangement, or a
currency composite.
UNIT 1 55
Exchange rate regimes Description
5. Crawling pegs The currency is adjusted periodically in small

amounts at a fixed rate or in response to changes
in selective quantitative indicators, such as past
inflation differentials vis-à-vis major trading partners,
differentials between the inflation target and
expected inflation in major trading partners. The rate
of crawl can be set to adjust for measured inflation
or other indicators (backward looking), or set at a
preannounced fixed rate and/or below the projected
inflation differentials (forward looking).
6. Exchange rates within The currency is maintained within certain fluctuation
crawling bands margins of at least ±1 percent around a central rate -
or the margin between the maximum and minimum
value of the exchange rate exceeds 2 percent - and
the central rate or margins are adjusted periodically
at a fixed rate or in response to changes in selective
quantitative indicators.
7. Managed floating with The monetary authority attempts to influence the
no predetermined path exchange rate without having a specific exchange
for the exchange rate rate path or target. Indicators for managing the rate
are broadly judgmental (e.g., balance of payments
position, international reserves, parallel market
developments), and adjustments may not be
automatic.
8. Independently floating The exchange rate is market-determined, with any
official foreign exchange market intervention aimed
at moderating the rate of change and preventing
undue fluctuations in the exchange rate, rather than
at establishing a level for it.
Table 1.3 Classification of exchange rate regime by IMF

Source: Adapted from IMF, http://www.imf.org/external/np/mfd/er/2006/eng/0706.htm
To summarise, a lot of countries in the world have some form of exchange

rate arrangement because keeping the currency in some kind of exchange rate
arrangement setting empowers a country’s monetary authority to implement a
desirable monetary policy on its economy.
Reading
Go to IMF website http://www.imf.org/external/index.htm to read

current developments in the international exchange rate system.
Fixed versus flexible currency regimes

Smaller countries find it convenient to peg their currencies with other major
currencies. The objective of the pegged arrangement is to stabilise the home
currency exchange rate so that it is easier to attract foreign investors. More
importantly, by fixing the currency exchange rates, there will be less risk in
conducting international trade, thus lowering the cost of international business
and promoting international trade. Another advantage is the reduction of
speculation activities in the foreign exchange markets.
An obvious disadvantage of fixed exchange rate regime is that the country is

more vulnerable to economic conditions in other countries. For example, if
Malaysia is pegging the ringgit value to US dollar, when the US experiences
serious unemployment problems, under the fixed exchange rate regime, Malaysian
exports to the US will drop as a result of income decline in the US and a drop
in US purchases of Malaysian goods. Consequently, productivity in Malaysia
may also decline and unemployment in Malaysia finally rises. Similarly when
the US experiences high inflation, they will increase their imports from Malaysia
(due to relatively cheaper imports, if the exchange rate is fixed), while Malaysia
will reduce imports from the US (due to relatively more expensive US prices).
This will force US production to go down and unemployment increases, but the
inverse will happen in Malaysia, i.e., due to huge export demand, production
will go up, leading to income rises and finally local prices will go up too. Thus,
high inflation in the US could be exported to Malaysia.
Another disadvantage is that the central banks need to maintain large quantities of
international currency reserve in the form of hard currency notes and gold for the
purpose of defending the value of the fixed rate. If the central banks do not have
sufficient foreign reserve to defend its fixed currency value, then it might need to
abandon the predetermined fixed rate.
When an exchange rate is fixed, it does not reflect the changing condition of the
country’s economic fundamental. Usually when the structure of an economy changes,
its trade balances with other countries also change. However, under fixed currency
regime, the fixed rate must only be adjusted administratively. Usually this is too
late and too costly to the economic health.
In a flexible exchange rate regime, exchange rate value is determined by demand

and supply forces in the market, without government intervention. This offers
complete flexibility for the exchange rate to adjust towards its equilibrium level as
soon as any changes occur in the economic fundamental.
Unlike the fixed exchange rate regime, a country does not need to follow
restrictive monetary and fiscal policies to pursue policies to counter other
economic problems.
Under a flexible exchange rate regime, a country is more isolated from

unemployment and inflation problems in other countries. In the case of high
inflation in the US as mentioned above, an increase in imports from Malaysia will
lead to an increased in demand for Malaysian ringgit. Such a shift in demand will
UNIT 1 57
cause the ringgit to appreciate against the US dollar. The higher ringgit exchange
rate will slow down the US imports from Malaysia, and maintain the volume of
Malaysian imports from the US; thus avoiding a potential transfer of the inflation
problem to Malaysia.
A single European currency

When the European Union (EU) was founded in 1957, the member states were
concentrated on closer economic integration. However, apparently closer monetary
cooperation was desirable for the region to develop further. The plan to set up
a full monetary union and a single currency was agreed in the 1992 Maastricht
Treaty, which spelt out the ‘convergence criteria’ or so-called ‘Maastricht criteria’
that covered low and stable inflation, exchange rate stability and sound fiscal
policy.
Obviously, with only one currency among the European Union, there will not be
any exchange risk. Hence, a single currency will promote international trade among
the countries. As of January 1999, eleven European countries (Austria, Belgium,
Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal
and Spain) agreed to use a new currency called the Euro to use alongside their own
individual currencies. Once these countries use the Euro as their currencies, they
essentially give up their own monetary policies. Because of the monetary policy
consideration, the UK, Denmark, and Sweden have not yet participated in the
Euro. The Euro is now the currency of 16 European Union countries: Belgium,
Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands,
Austria, Portugal, Finland, Malta, Cyprus and Slovenia. An independent
European Central Bank (ECB) was created as the national central bank of the
member states having adopted the Euro. Figure 1.11 lists down the timetable of
the Euro currency adoption.
Year Country
1999 Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the
Netherlands, Austria, Portugal and Finland
2001 Greece
2002 Introduction of Euro banknotes and coins
2007 Slovenia
2008 Cyprus, Malta
2009 Slovakia
Figure 1.11 Entry date of the Euro currency

Source: http://ec.europa.eu/economy_finance/the_euro/index_en.htm?cs_mid=2946
The benefits of having a single currency in the region include making travel easier,
facilitates cross-border trade among the member states, lowers business costs
(without need to hedge exchange rate risk), increases price transparency, and more
importantly, gives the EU a more powerful voice in the world both economically
and politically.
Currently, the Euro is the currency for about 329 million people in the European
region. It is also established as one of the major foreign exchange reserve held by
many central banks in the world. Therefore, it is not surprising that the Euro
has rapidly become the second most important international currency after the
US dollar. In fact, in some respects, for example the value of cash in circulation,
the Euro has overtaken the role of US dollar. You are encouraged to visit www.
euro.gov.uk to get some information about how businesses are affected by the
introduction of the Euro.
The following reading provides a comprehensive explanation of a currency system

and the underlying political and economic explanations in the evolution of the
exchange rate system.
Web Reference
Go to ECB website http://www.ecb.int/home/html/index.en.html

to read the current development or issues affecting the Euro
currency.
UNIT 1 59
Activity 1.7
Read the following news article and answer the questions.
Single currency for SAR and Singapore proposed
Financial Secretary Sir Donald Tsang suggested yesterday that

Hong Kong and Singapore consider moving to a common
currency that could later be widened to the rest of Asia.
‘I feel brave and courageous in even uttering these words. It’s the
unthinkable. But we must think the unthinkable now,’ Sir Donald
said in an interview published by the Straits Times, a leading
Singapore newspaper.
Depegging the Hong Kong dollar and adopting a common Asian

currency could make Hong Kong and other Asian countries less
vulnerable to worldwide joint-currency forces, Sir Donald was
quoted by the Straits Times as saying.
In calling for such an Asian monetary union, he said Hong Kong

would be prepared to give up its currency peg to the US dollar and
asked Singapore to give up its managed float system as well.
Adding to his proposal, Sir Donald said he was thinking in terms

of a horizon of five to seven years.
‘Asia now embraces so many individual sovereign currencies that

it is probably very vulnerable,’ Sir Donald said, explaining why a
common Asian currency would be a recipe for stability.
Source: Ada Ng (1999) Hong Kong Standard TIGERNET,

October 22.
1. What are the difficulties in putting together a single currency

for Hong Kong, Singapore, and the rest of Asia?
2. What are the advantages of putting together a single Asian

currency?
Summary
This completes the last section of Unit 1. This lesson discussed

how the modern international monetary system evolved from the
classical gold standard, the regime during the inter-war period, the
Bretton Wood system, to the flexible regime after the collapse of the
Bretton Wood system. Up to the present day, we have eight specific
categories of exchange rate regimes, as classified by the IMF. The
IMF scheme ranks exchange rate regime on the basis of their degree
of flexibility and the existence of formal or informal commitments
to the exchange rate paths. Basically, they all belong to either one of
the two extreme cases of exchange rate systems, i.e., fixed or flexible
currency regimes. Both fixed and flexible currency regimes have
their advantages and disadvantages on the stability of international
trade, inflation, international reserve, and resulted in different
degrees of external vulnerability and local policy effectiveness. Last
but not least, the Euro single currency regime is addressed. This is
one role example of the single currency regime that progressed very
successfully until the present day.
Reading

(pages 183 – 188).
Self-test 1.5
1. Under a currency board, the Hong Kong dollar is tied to the

US dollar. Explain how a depreciation of the Japanese yen
against the US dollar would affect the import of Japanese
goods in Hong Kong.
2. During the Asian crisis, some Asian central banks raised their
interest rates to prevent their currencies from weakening. Yet,
the currencies weakened anyway. Offer your opinion as to
why the central banks’ efforts at indirect intervention did not
work.
UNIT 1 61
3. How can a central bank use direct intervention to change the

value of a currency? Explain why a central bank may desire to
smooth exchange rate movements of its currency.
4. Assume that Belgium, one of the European countries that uses

the Euro as its currency, would prefer that its currency
depreciate against the dollar. Can it apply central bank
intervention to achieve this objective? Explain.
Feedback
Activity 1.7
1. It is extremely hard to ask all these countries to give up

control of their central banks and monetary policies. For a
single currency system to work, you need a single authority
(called the Monetary Union in the European currency system)
to control the money supply and the printing of money.
Politically, this is impossible for these Southeast Asian
countries. In addition, different countries are at different
stages of their economic growth and each country may have
its own preference in terms of monetary and fiscal policies in
promoting its economy. Again, some countries such as
Thailand or the Philippines may pursue strategies very
different from Hong Kong or Singapore. Essentially, countries
may find it difficult not to control their own monetary
policies.
2. It would be more difficult for speculators to speculate on

the currency. It would promote international trade among
these countries because there would not be exchange rate risks
any more.
UNIT 1 63
Summary of Unit 1
Summary
Congratulations! You have finished Unit 1. By now, you should

know the basics so that you are able to understand more complex
issues in international financial management. Every day a lot
of international events occur and you should be able to use
some of the concepts from Unit 1 to analyse these events. The
news articles from Wall Street Journal, The Edge Daily and The
Start illustrate this point.
I would like to emphasise that you need to follow some good

habits in studying international financial management. Otherwise
you will be rather confused in other units. First, for anything
that involves exchange rates, you need to think in a systematic
fashion. This means that you should have a system. For instance, I
personally always think in direct quotations only and always write
exchange rates with two units (e.g., $/£… etc.). Second, when
we learn international financial management, we should try to
understand some simple calculations first before we use formulas.
For example, in the speculation on anticipated exchange rate
changes section, do the mathematics first before following any
formula.
The main points:
1. MNC is defined as a corporation that have business engagement

across national borders. MNC produce, distribute and sell
the product of their business, including both goods and
services, in many countries or even in the whole world. They
often have operating subsidiaries, branches, or affiliations
located in many countries.
2. The main goal of an MNC is to maximise shareholder wealth.
3. The main factors threatening the MNC goal is the agency

problem. Besides, MNCs also need to pay high attention
to environmental, regulatory and ethical constraints that
might interfere with the MNC’s goal.
4. MNCs must ensure the organisation management is well

motivated for the managers and workers, and a good rewards
system is installed to compensate good performance. To reduce
agency problems, MNCs can employ various preventive
methods. At the management level, a proper corporate
governance practice is useful. At the industry level, the threat
of a hostile takeover can ensure the MNC remain competitive
always. Another form of corporate control is monitoring by
institutional investors.
5. The theory of absolute advantage and comparative advantage

look at the welfare gain in explaining international trade. The
imperfect market theory and product cycle theory focus on
market and firm level reasoning in explaining why firms have
to go beyond national borders to expand their business.
6. Methods such as licensing and franchising involve little or

low capital investment but need to distribute some of the
profits to other parties. While acquisition of foreign firms and
formation of foreign subsidiaries are popular, these methods
involve a substantial capital investment but offer the potential
for large returns. There is no clear answer which method is
the best. Every method has its advantages at different stage of
business expansion but then it may invite great challenges
when the business expansion has gone to the next level.
7. A direct foreign exchange quotation refers to the value of a

foreign currency in the local currency. On the other hand,
indirect quotation is the opposite of direct quotation, the
value of foreign currency per unit of local currency. In
Malaysia, spot prices are quoted for over 20 currency pairs
every working day, quotations are available for OTC
transactions, spot contracts, forward exchange contracts,
foreign currency notes and currency options.
8. Cross exchange rate reflects the amount of one foreign

currency per unit of another foreign currency. A spot rate is
the exchange rate of purchasing or selling currencies for
immediate delivery, usually within 2 working days. A forward
rate is the exchange rate of purchasing or selling currencies in
future periods at a rate agreed upon today. The positive and
negative differences between the forward rate and the spot
rate are called forward premiums and discounts, respectively.
9. The equilibrium exchange rate between two currencies at any

point in time is based on the demand and supply conditions.
The demand for foreign currency is the varying quantity of
foreign currency that would be purchased by market
UNIT 1 65
participants given various levels of foreign exchange rates. The

supply for foreign currency on the other hand is the varying
quantity of foreign currency that would be offered for sale
given various levels of foreign exchange rates. Appreciation
and depreciation of exchange rates means an increase and a
decrease in currency value, respectively.
10. As the market is not always in equilibrium, there will always

be speculative trading on currencies to gain profit from
speculating on anticipated exchange rate changes.
11. Gold and other commodity of value, such as silver, has long
been used as the medium of exchange to facilitate the transfer
of goods and services across borders. The gold standard as an
international monetary system was recognised widely in
Western Europe in the 1870s. During the interwar period
1915 – 1943, the gold system was ended, where currencies
were allowed to fluctuate over fairly wide ranges in terms of
gold and its exchange rates with other countries World War
II ended in 1944. After the war, the Bretton Wood system
was installed to establish a US dollar based international
monetary system. However, the Bretton Wood system
collapsed in 1973 due to tremendous selling pressure on the
dollar. After the US was free to float, other major currencies
followed suit. That was the beginning of a floating exchange
rate system.
12. According to IMF, there are eight specific categories:

(1) exchange arrangements with no separate legal tender,
(2) currency board arrangements, (3) conventional fixed peg
arrangements, (4) pegged exchange rates within horizontal
bands, (5) crawling pegs, (6) exchange rates within crawling
bands, (7) managed floating with no predetermined path for
the exchange rate, and (8) independently floating.
13. Fixed regime stabilises currency exchange rate, involves less

risks, lowers cost of business and lessens speculation activities
in the markets. However, a country with the fixed regime is
more vulnerable to external economic conditions and the
central banks need to maintain large quantities of international
currency reserve. The fixed regime also does not reflect the
economic fundamental. In a flexible exchange rate regime,
exchange rate adjusts towards its equilibrium level as soon
as any changes occur in the economic fundamental. A country
can conduct independent monetary and fiscal policies to
pursue policies to counter other economic problems. The
country is also more isolated from unemployment and
inflation problems in other countries.
14. With the Euro, there will not be any exchange risk among
the member countries. The Euro also makes travel easier,
facilitates cross-border trade among the member states,
lowers business costs, increases price transparency, and more
importantly, gives the EU a more powerful voice in the world
both economically and politically.
UNIT 1 67
Suggested Answers to Self-tests
Feedback
Self-test 1.1
1. NAFTA enables US-based MNCs to enter Canada and

Mexico with fewer trade restrictions. US-based MNCs now
have a bigger market to sell their goods and services. At the
same time, competition is increasing. Canada-based and
Mexico-based MNCs are also able to penetrate the US
markets. The risk for the MNCs is that their increase in sales
in Canada and Mexico may be more than offset by their loss
in sales in the US.
2. An MNC’s cash flows could be reduced in the following

ways. First, a decline in travel would affect any MNCs that
have business in travel-related industries. The airline, hotel
and tourist-related industries were expected to experience a
decline in business. Layoffs were announced immediately
by many of these MNCs. Second, these effects on travel-
related industries can carry over to other industries and
weaken economies. Third, the cost of international trade
increased as a result of tighter restrictions on some products.
Fourth, some MNCs incurred expenses as a result of
increasing security to protect their employees.
3. Political risk is defined as government actions or change in

policies that result in loss for business operations. Political
risk increases the rate of return required to invest in foreign
projects. Foreign investors would require a higher risk
premium to compensate higher risk he has to bear. Some
foreign projects would have been feasible if there was no
political risk, but will not be feasible because of political risk.
Self-test 1.2
1. The imperfect markets theory explains the phenomenon. It

would be cost effective to make the soft drinks in the host
countries. The raw materials (sugar and water) are much
cheaper in the host countries as compared with the US (after
the inclusion of transportation costs).
2. The operating characteristics of the firm (what it produces or

sells) and the risk perception of international business will
influence the degree to which a firm becomes internationalised.
Several other factors such as access to capital could also
be relevant here. Firms that are labour-intensive could more
easily capitalise on low-wage countries while firms that rely
on technological advances could not.
3. Internet allows for easy and low-cost communication between

countries, so that firms could now develop contacts with
potential customers overseas by having a website. Many firms
use their website to identify the products that they sell, along
with the prices for each product. This allows them to easily
advertise their products to potential importers anywhere in
the world without mailing brochures to various countries. In
addition, they can add to their product line and change prices
by simply revising their website, so importers are kept abreast
of the exporter’s product information by monitoring the
exporter’s website periodically. Firms can also use their websites
to accept orders online. Some firms with an international
reputation use their brand name to advertise products over
the internet. They may use manufacturers in some foreign
countries to produce some of their products subject to their
specification.
Self-test 1.3
1. A joint venture cuts down the ‘learning curve’ for a new

entrant in a new market and at the same time limits the
political risk. In this case, by doing a joint venture with
General Motors, Toyota can minimise anti-Japanese sentiment
(limit political risk) and be able to use the American style of
management.
2. An acquisition will typically result in greater growth, but it is

more risky because it normally requires a larger investment and
the decision can not be easily reversed once the acquisition is
made.
3. Coca Cola and PepsiCo still have new international

opportunities because countries are at various stages of
development. Some countries have just recently opened their
borders to MNCs. Many of these countries do not offer
sufficient food or drink products to their consumers.
UNIT 1 69
Self-test 1.4
1. ($.81 − $.7938)/$.81 = .02 or 2%
2. $.17/$.008 = 21.25 1 zloty = 21.25 yen
3. A relative decline in Asian economic growth will reduce

Asian demand for US products, which places upward pressure
on Asian currencies. However, given the change in interest
rates, Asian corporations with excess cash may now invest in
the US or other countries, thereby increasing the demand for
US dollars. Thus, a decline in Asian interest rates will place
downward pressure on the value of the Asian currencies. The
overall impact depends on the magnitude of the forces just
described.
4. ($1.66 − $1.73)/$1.73 = −4.05%
Expected depreciation of 4.05% percent
5. (F − S)/S = ($.102 − $.10)/$.10 × (360/90) = +.08, or +8%,

which reflects a 8% discount
Self-test 1.5
1. If the Japanese yen depreciates against the dollar, this is the

same as the Japanese yen depreciating against the Hong Kong
dollar, because the dollar and the Hong Kong dollar exchange
rate remains the same. When the Japanese yen depreciates
against the Hong Kong dollar, Japan’s exports to Hong Kong
will be cheaper in Hong Kong in terms of Hong Kong
dollars. Other things being equal, Hong Kong people would
buy more Japanese exports. Then Hong Kong imports from
Japan would go up.
2. The higher interest rates did not attract sufficient funds to

offset the outflow of funds, as investors had no confidence
that the currencies would stabilise and were unwilling to
invest in Asia. The risk of putting money in Asia in 1997 –1998
is just too high to attract investors.
3. Central banks can use their currency reserves to buy up a

specific currency in the foreign exchange market in order to
place upward pressure on that currency. Central banks can
also attempt to force currency depreciation by flooding
the market with that specific currency (selling that currency
in the foreign exchange market in exchange for other
currencies). Abrupt movements in a currency’s value may
cause more volatile business cycles, and may cause more
concern in financial markets (and therefore more volatility in
these markets). Central bank intervention used to smooth
exchange rate movements may stabilise the economy and
financial markets.
4. It cannot apply intervention on its own because the European

Central Bank (ECB) controls the money supply of Euros.
Belgium is subject to the intervention decisions of the ECB.
A member of the Euro zone surrenders its domestic
sovereignty on monetary policy to ECB based in Frankfurt,
Germany.
UNIT 1 71
References
Bloomberg: http://www.bloomberg.com/?b=0&Intro=intro3 Accessed 4 March 2010.
CNN Financial News: http://money.cnn.com/ Accessed 4 March 2010.
European Central Bank: http://www.ecb.int/home/html/index.en.html Accessed

4 March 2010.
International Monetary Fund: http://www.imf.org/external/index.htm Accessed

4 March 2010.
Madura, J (2008) International Corporate Finance, 9 th edn, USA: Thomson

Learning.
The Edge Daily: http://www.theedgedaily.com/cms/index.jsp Accessed 4 March

2010.
Yahoo Finance: http://biz.yahoo.com/topic/currency/ Accessed 4 March 2010.

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UNIT 1 i

Introduction to international financial management

EXTERNAL COURSE ASSESSOR

© 2010 Wawasan Open University

First revision 2015

Wawasan Open University [DU013(P)]

1.1 Managing the Multinational Corporation (MNC) 7

The definition of MNC 7

The goals and constraints of an MNC 8

Conflicts against the MNC goal 8

Corporate control and financial management of an MNC 9

Methods to prevent agency problem 11

Constraints interfering with the MNC’s goal 11

Suggested answers to activity 13

1.2 Theories of international business 15

Theory of absolute advantage 15

Theory of comparative advantage 17

Imperfect markets theory 19

Product cycle theory 19

Suggested answers to activity 22

1.3 International business methods 23

Acquisitions of existing operations 24

Establishing new foreign subsidiaries 25

Which mode of entries is the best? 25

Suggested answers to activity 28

1.4 Foreign exchange rate quotations 29

Currency quotations in Malaysia 29

Cross exchange rate calculations 33

Forward premiums and discounts calculations 34

Forward premiums and discounts interpretation 35

Cross exchange rates and forward premiums and discounts 35

The exchange rate equilibrium 36

Measuring exchange rate movements 36

Demand for a currency 37

The exchange rate equilibrium 39

Factors that influence equilibrium exchange rate 41

Speculating on anticipated exchange rate changes 43

Suggested answers to activities 47

1.5 The history of different exchange rate systems 49

The pre-classic exchange regime (pre 1870) 50

Classical gold standard (1870 –1914) 50

Interwar period (1915 –1943) 51

Gold-exchange standard or the Bretton Wood system 52

A managed floating exchange rate system (1973 –present) 53

The present currency regimes 54

Fixed versus flexible currency regimes 56

A single European currency 57

Suggested answers to activity 61

Suggested answers to self-tests 67

Unit 1 introduces you to the various types of international business. This is

Unit 5 discusses the various short term financing alternatives by Multinational

By the end of this course, you should be able to:

1. Gain an overview of the various types of exchange rate system.

2. Gain an overview of international business strategies.

4. Execute arbitrage and speculative currency strategy in the spot and

5. Evaluate the feasibility of long-term multinational international project.

6. Effectively manage a firm’s exposure to foreign exchange rate risk in its

I nternational business activity is not a new phenomenon in world economics.

Even if a corporation attempted to focus on domestic operations only, it would be

Managers of MNCs must understand the international environment and

Obviously, you need to understand financial management in a complex

• international financial markets

• sociology and political science