Explain the theory of purchasing power parity (PPP).

Based on this theory, what

is a general forecast of the values of currencies in countries with high inflation?
PPP suggests that the purchasing power of a consumer will be similar when
purchasing goods in a foreign country or in the home country. If inflation in a foreign country
differs from inflation in the home country, the exchange rate will adjust to maintain equal
purchasing power.
Currencies in countries with high inflation will be weak according to PPP, causing the purchasing
power of goods in the home country versus these countries to be similar

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.
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.

Central bank intervention used to smooth exchange rate movements may stabilize the economy
and financial markets.

What is difference between Fixed Floating system and free floating system?
Under a fixed exchange rate system, the governments attempted to maintain exchange rates within 1% of
the initially set value. Under a freely floating system, government intervention would be non-existent.

Why do you think most crises in countries (such as the Asian crisis) cause the
local currency to weaken abruptly? Is it because of trade or capital flows?
Capital flows have a larger influence. In general, crises tend to cause investors to expect that there will
be less investment in the country in the future and also cause concern that any existing investments will
generate poor returns. Thus, as investors liquidate their investments and convert the local currency
into other currencies to invest elsewhere, downward pressure is placed on the local currency.

What is the expected relationship between the relative real interest rates of
two countries and the exchange rate of their currencies?
The higher the real interest rate of a country relative to another country, the stronger will be its home
currency, other things equal.
 Explain why some financial institutions prefer to provide credit in financial
markets outside their own country?
Financial institutions may believe that they can earn a higher return by providing credit in foreign
financial markets if interest rate levels are higher and if the economic conditions are strong so that the
risk of default on credit provided is low. The institutions may also want to diversity their credit so that
they are not too exposed to the economic conditions in any single country

Identify the more obvious risks faced by MNCs that expand internationally?
First, there is the risk of poor economic conditions in the foreign country. Second, there is country risk,
which reflects the risk of changing government or public attitudes toward the MNC. Third, there is
exchange rate risk, which can affect the performance of the MNC in the foreign country.

Explain why unfavorable economic or political conditions affect the MNC’s cash
flows, required rate of return, and valuation.
Weak economic conditions or unstable political conditions in a foreign country can reduce cash flows
received by the MNC, or they can result in a higher required rate of return for the MNC. Either of these
effects results in a lower valuation of the MNC.
 How firm’s engage in international business? Explain thoroughly
Firms use several methods to conduct international business. The most common methods are these:

1. International trade
2. Licensing
3. Franchising
4. Joint Ventures
5. Acquisitions of existing operations
6. Establishing new foreign subsidiaries

International Trade

International trade is a relatively conservative approach that can be used by firms to penetrate
markets (by exporting) or to obtain supplies at a low cost (importing). This approach entails minimal risk
because the firm does not place of its capital at risk.

Licensing

Licensing obligates a firm to provide its technology (copyrights, patents, trademarks, or trade names in
exchange for fees or some other specified benefits.

Franchising

Franchising obligates a firm to provide a specialized sales or service strategy,support assistance,

and possibly an initial investment in the franchise in exchange for periodic fees

Joint venture

A joint venture is a venture that is operated by two or more firms.

Example Fuji & Xerox.

Acquisitions of Existing Operations

Firms frequently acquire other firms in foreign countries as a means of penetrating foreign markets.

For example, SCB acquired American Express

Disadvantage : Very high capital needed.

Establishing New Foreign Subsidiaries

Firms can also penetrate foreign markets by establishing new operation subsidiaries to produce and sell
their products. Like a foreign acquisition, this process requires a large investment.
 Explain the constraints interfering with MNC’s goal?
When financial managers of MNCs attempt to maximize their firm's value, they are confronted with
various constraints that can be classified as environmental, regulatory, or ethical in nature.

Environmental constraints:

Each country enforces its own environmental constraints. Some countries may enforce more of these
restrictions on a subsidiary whose parent is based in a different country. Building codes, disposal of
production, waste materials, and pollution controls are examples of restrictions that force subsidiaries
to incur additional costs. Many European countries have recently imposed rougher antipollution laws as
a result of severe pollution problems.

Regulatory constraints:

Each country also enforces its own regulatory constraints pertaining to taxes, currency convertibility
rules, earnings remittance restrictions, and other regulations that can affect cash flows of a subsidiary
established there.

Ethical Constraints:

There is no consensus standard of business conduct that applies to all countries. A business practice that
is perceived unethical in one country may be totally ethical in another.

Example: Bribes, Sexual products in Arab countries.

 Briefly describe the exchange rate systems used by various governments?
Exchange rate systems can be classified according to the degree to which the rates are controlled by the
government:

1. fixed
2. freely floating
3. managed float
4. pegged

Fixed Exchange Rate System

System: Rates are held constant or allowed to fluctuate within very narrow bands only.

Examples: Bretton Woods’s era (1944-1971), Smithsonian Agreement (1971)

Freely Floating Exchange Rate System

Rates are determined by market forces without governmental intervention.

1. Each country is more insulated from the economic problems of other countries.

2. Central bank interventions just to control exchange rates are not needed.

3. Governments are not constrained by the need to maintain exchange rates when setting new
policies.

Managed Float Exchange Rate System

Exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However,
governments may intervene to prevent the rates from moving too much in a certain direction.

Disadvantage: A government may manipulate its exchange rates such that its own country benefits at
the expense of other countries.

Pegged Exchange Rate System

The currency’s value is pegged to a foreign currency or to some unit of account, and thus moves in line
with that currency or unit against other currencies.

Examples: European Economic Community’s snake arrangement (1972), European Monetary System’s
exchange rate mechanism (1979), Mexican peso’s peg to the U.S. dollar (1994)