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Ch-2, RM Joshi
International Trade Theory and Application - Handout given by Prof. Chawla
International Trade Theories
International trade is the exchange of goods and services across borders. Export
structures vary across countries. A number of international trade theories can
explain these different structures.
Comparative Advantage Theory

Comparative Advantage explains and predicts trade of goods where absolute

advantages may not exist.
Opportunity Cost the amount of other goods which have to be given up to
product one unit of a good.
Comparative Advantage must be explained by:
Comparative Production Cost depends on the commoditys production
process.
Production Factors such as labor, land, capital, and natural resources.

Heckscher-Ohlin Theorem

Countries export goods that make intensive use of the countrys abundant factor.
Countries import goods that make intensive use of the countrys scarce factor.
Differences in comparative advantage are attributed to differences in the structure of
the economy.
Assumptions:
Countries vary in the availability of various factors of production.
The Production Function is identical anywhere in the world.
The amount of output produced by using any given amount of capital
and labor.
Technology is constant in all trading countries.
Conditions of demand for production factors are the same in all countries.

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Implications
Trade should be greatest between countries with the greatest differences in
economic structure.
Trade should cause countries to specialize more.
Trade policy should take the form of trade restrictions.
Countries should export goods that make use of the abundant factors.
Free trade should equalize factor prices between countries with similar
relative factor endowments.
Factor prices should be nearly equal between countries with more liberal
mutual trade.
International investment should be stimulated by difference in factor
endowments.
Factor endowment theory
A trade theory which holds that nations will produce and export products that use
large amounts of production factors that they have in abundance and will import
products requiring a large amount of production factors that they lack. This theory is
also known as the HeckscherOhlin theory (after the two economists who first
developed it).

The Leontief Paradox

Leontief challenges Heckscher-Ohlin on a number of grounds.

The U.S (a capital intensive nation) exports labor-intensive goods.
The U.S also exports technically sophisticated goods that require skilled
labor.
The U.S imports capital intensive goods made with unskilled labor.
Stimulated a search for explanations.
Demand bias for capital-investment goods.
Existence of trade barriers.
Importance of natural resources
Prevalence of factor-intensity reversals.

Human Skills and Technology-Based View

Keesing indicated that trade direction and flow is predicted by gaps in human skills
and technology.
Nations with higher levels of humans skills and technology will produce and export
goods to nations with lower levels.
Human Skills and Technology-Based View
Human Skills are predicted by
Level of development in the scientific, technical, managerial, and skilled labor
sectors.

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Technology level is predicted by:

capital-intensive technology development
imitation lag that exists as technology innovations diffuse to developing
areas.

The Product Life-Cycle Model

Product innovation and initial use occurs first in higher income countries
Diffuses to middle and lower income countries as technology and skills gaps
overcome and consumer preferences switch to the newer products.
Several trends emerge in PLC:
The export performance of the mature innovating country is better than
others.
Technology is better in the mature countries as products diffuse production
tends to move from technology-intensive to labor-intensive.
Countries that were innovators can fall from that place.
Trade may increase in later stages of product maturity as costs and prices
decline and production economies rise.

Exhibit 2-5: Product cycle model of international trade innovating country

Exhibit 2-6: Product cycle model of international trade imitating country

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Linders Income-Preference Similarity Theory

Developed countries trade more than less developed countries (assumption)

Trade should take place between developed nations producing manufactured
products and less developed nations producing primary products (e.g. natural
resources) and labor-intensive goods.
According to Linder, the range of production is determined by internal demand.
Countries with similar internal demand conditions should therefore trade. This is
called Preference Similarity.

The New Trade Theory

Countries do not specialize and trade solely to take advantages of differences.

They also trade because of increasing returns.
Because of economies of scale, there are increasing returns to specialization.
Economies of scale reduction of manufacturing cost per unit as a result of
increased production quantity during a given period.
Inter-industry trade determined by Heckscher-Ohlin.
Intra-industry trade driven by increasing returns resulting from specialization within
the industry.
Externality when the actions of one agent directly affect the environment of
another.

Theory Assessment
These theories provide insights in international trade.
No theorem can fully explain the range of motives for international trade.

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Theories of International Investment

The FDI theories explain the reason why FDI occurs and the determinants of FDI
They are grouped into three categories:-

1).Traditional theories Traditional theories are based on neo-classical economic and

explain FDI in terms of location-specific advantages.

2).Modern theories Modern theories emphasise the fact that product and factor markets
are imperfect both domestically and internationally and that considerable transactional
costs are involved in market solutions. Also they acknowledge that managerial and
organisational functions play an important role in undertaking FDI.

3).Radical theories - The radical theories, these take a more critical view of Multinational
National Corporation (MNCs).

Monopolistic Advantage Theory

Product and Factor Market Imperfections

International Product Life Cycle
Other Theories
Follow-the-leader theory
Cross investment
Internationalism theory
Dunnings Eclectic Theory of International Production
Ownership-specific
Internalization

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Location-specific

TRADITIONAL THEORY
Capital arbitrage theory - The theory states that direct investment flows from
countries where profitability is low to countries where profitability is high. It means
therefore that capital is mobile both nationally and internationally. But sometimes
implication is that countries with abundant capital should export and countries with less
capital should import. If there was a link between the long-term interest rate and return on
capital, portfolio investment and FDI should be moving in the same direction.
International trade theory-the country will specialise in production of, and export those
commodities which make intensive use of the countrys relatively abundant factor.

MODERN THEORY
Product-cycle theory New products appear first in the most advanced economy in
respond to demand conditions. The maturing product stage is described by standardisation
of the product, increased economies of scale, high demand and low price. The
standardised product stage is reached when the commodity is sold entirely on price basis.

Internalisation Theories Of FDI

The theory explain that why the cross-border transactions of intermediate products are
organised by hierarchies rather than determined by market forces.

Theory Of Appropriability. The theory explains why there is a strong presence of hightechnology industries among MNCs.

Eclectic Theory of FDI

The theory tries to offer a general framework for determining the extent and pattern of both
foreign-owned production undertaken by a countrys own enterprises, and that of domestic
production owned or controlled by foreign firm. Dunning and Lundan(2008) assert that, the
eclectic theory of international production enlarges the theoretical framework by including
both home-country and host-country characteristics as international explanatory factors. It
argues that the extent, form, and patterns of international production are determined by the
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configuration of three sets of advantages as perceived by the enterprises.

First Ownership (O) advantage

2nd Location (L) and

3rd Internalization (I) advantage in order for the firm to transfer its ownership
advantages across national boundary

Theories of FDI may be classified under the following headings:

Production Cycle Theory of Vernon
Production cycle theory developed by Vernon in 1966 was used to explain certain types of
foreign direct investment made by U.S. companies in Western Europe after the Second
World War in the manufacturing industry.
Vernon believes that there are four stages of production cycle: innovation, growth, maturity
and decline. According to Vernon, in the first stage the U.S. transnational companies
create new innovative products for local consumption and export the surplus in
order to serve also the foreign markets. According to the theory of the production cycle,
after the Second World War in Europe has increased demand for manufactured products
like those produced in USA. Thus, American firms began to export, having the advantage
of technology on international competitors. If in the first stage of the production cycle,
manufacturers have an advantage by possessing new technologies, as the product
develops also the technology becomes known. Manufacturers will standardize the
product, but there will be companies that you will copy it. Thereby, European firms
have started imitating American products that U.S. firms were exporting to these countries.
US companies were forced to perform production facilities on the local markets to maintain
their market shares in those areas. This theory managed to explain certain types of
investments in Europe Western made by U.S. companies between 1950-1970. Although
there are areas where Americans have not possessed the technological advantage and
foreign direct investments were made during that period.
Theory of Exchange Rates on Imperfect Capital Markets
This is another theory which tried to explain FDI. Initially the foreign exchange risk has
been analyzed from the perspective of international trade. Itagaki (1981) and Cushman
(1985) analyzed the influence of uncertainty as a factor of FDI. In the only empirical
analysis made so far, Cushman shows that real exchange rate increase stimulated FDI
made by USD, while a foreign currency appreciation has reduced American FDI.
Currency risk rate theory cannot explain simultaneous foreign direct investment between
countries with different currencies. The sustainers argue that such investments are made
in different times, but there are enough cases that contradict these claims.

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The Internalisation Theory

This theory tries to explain the growth of transnational companies and their motivations for
achieving foreign direct investment. In his Doctoral Dissertation, Hymer identified two
major determinants of FDI. One was the removal of competition. The other was the
advantages which some firms possess in a particular activity (Hymer, 1976). Buckley
and Casson, who founded the theory demonstrates that transnational companies are
organizing their internal activities so as to develop specific advantages, which then to be
exploited.

Internalisation theory is considered very important also by Dunning, who uses it in the
eclectic theory, but also argues that this explains only part of FDI flows.
Hennart (1982) develops the idea of internalization by developing models between the
two types of integration: vertical and horizontal.
The concept of firm-specific advantages and demonstrates that FDI take place only if
the benefits of exploiting firm-specific advantages outweigh the relative costs of the
operations abroad. According to Hymer (1976) the MNE appears due to the market
imperfections that led to a divergence from perfect competition in the final product
market. Hymer has discussed the problem of information costs for foreign firms
respected to local firms, different treatment of governments, currency risk (Eden and
Miller, 2004). The result meant the same conclusion: transnational companies face
some adjustment costs when the investments are made abroad. Hymer recognized that
FDI is a firm-level strategy decision rather than a capital-market financial decision.

The Eclectic Paradigm of Dunning

The eclectic theory developed by professor Dunning is a mix of three different theories of
direct foreign investments (O-L-I):

O from Ownership advantages: This refer to intangible assets, which are, at least
for a while exclusive possesses of the company and may be transferred within
transnational companies at low costs, leading either to higher incomes or reduced costs.
But TNCs operations performed in different countries face some additional costs.
Thereby to successfully enter a foreign market, a company must have certain
characteristics that would triumph over operating costs on a foreign market. These
advantages are the property competences or the specific benefits of the company. The
firm has a monopoly over its own specific advantages and using them abroad leads to
higher marginal profitability or lower marginal cost than other competitors.
There are three types of specific advantages:
a) Monopoly advantages in the form of privileged access to markets through
ownership of natural limited resources, patents, trademarks;
b) Technology, knowledge broadly defined so as to contain all forms of innovation
activities
c) Economies of large size such as economies of learning, economies of scale and
scope, greater access to financial capital;

L from Location: When the first condition is fulfilled, it must be more advantageous
for the company that owns them to use them itself rather than sell them or rent them to
foreign firms. Location advantages of different countries are de key factors to

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determining who will become host countries for the activities of the transnational
corporations. The specific advantages of each country can be divided into three
categories:
a) The economic benefits consist of quantitative and qualitative factors of
production, costs of transport, telecommunications, market size etc.
b) Political advantages: common and specific government policies that affect FDI
flows
c) Social advantages: includes distance between the home and home countries,
cultural diversity, attitude towards strangers etc.

I from Internalisation: Supposing the first two conditions are met, it must be
profitable for the company the use of these advantages, in collaboration with at least
some factors outside the country of origin . This third characteristic of the eclectic
paradigm OLI offers a framework for assessing different ways in which the company will
exploit its powers from the sale of goods and services to various agreements that might
be signed between the companies. As cross-border market Internalisation benefits is
higher the more the firm will want to engage in foreign production rather than offering
this right under license, franchise.
Eclectic paradigm OLI shows that OLI parameters are different from company to
company and depend on context and reflect the economic, political, social
characteristics of the host country. Therefore the objectives and strategies of the firms,
the magnitude and pattern of production will depend on the challenges and opportunities
offered by different types of countries.

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INTERNATIONAL ECONOMIC INTEGRATION

Regional Economic Integration - agreements between countries in a geographic region
to reduce tariff and non-tariff barriers to the free flow of goods, services, and factors of
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production between each other

Levels of Regional Economic Integration / Regional or Preferential Trade Agreement
1.

2.
3.
4.

5.

A free trade area eliminates all barriers to the trade of goods and services among
member countries

European Free Trade Association (EFTA) - Norway, Iceland, Liechtenstein,

and Switzerland

North American Free Trade Agreement (NAFTA) - U.S., Canada, and Mexico
A customs union eliminates trade barriers between member countries and adopts
a common external trade policy

Andean Community (Bolivia, Columbia, Ecuador, and Peru)

A common market has no barriers to trade between member countries, a common
external trade policy, and the free movement of the factors of production

MERCOSUR (Brazil, Argentina, Paraguay, and Uruguay)

An economic union has the free flow of products and factors of production
between members, a common external trade policy, a common currency, a harmonized tax
rate, and a common monetary and fiscal policy

European Union (EU)

A political union involves a central political apparatus that coordinates the
economic, social, and foreign policy of member states

the EU is headed toward at least partial political union, and the U.S. is an
example of even closer political union

Difference between FTA and PTA

What is PTA?
PTA stands for Preferential Trade Agreement, and is an economic pact between
participating countries to help improve quantity of trade by gradually reducing tariffs
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between participating countries. The barriers to trade are not altogether removed, but a
preference is shown towards participating countries in comparison to other countries of the
world. There are departures from WTO in the sense that duties and tariffs are reduced
significantly. WTO aims to have same tariffs and duties in international trade between
countries but in the case of PTA, these tariffs are reduced much more than what
GATT allows.
What is FTA?
FTA stands for Free Trade Agreement, and is considered to be an advanced stage in trade
between participating countries of a trade block. These are countries that agree to
eliminate altogether artificial barriers and tariffs in trade between participating
countries. Countries that share cultural links and geographical links are much more likely
to have a trade block of this magnitude. One such block is European Union where free
trade is practiced between the countries of the union.
What is the difference between FTA and PTA?
The aim of PTA and FTA being similar, thin line dividing these agreements gets blurred at
times but it is a fact that PTA is always a starting point and FTA is the final goal of
participating countries in a trade block. Whereas PTA aims at reducing tariffs, FTA aims
at elimination of tariffs altogether.
Tariff Barriers vs Non Tariff Barriers
Importing goods from foreign countries at cheap prices hits domestic producers badly. As
such, countries impose taxes on goods coming from abroad to make their cost comparable
with domestic goods. These are called tariff barriers.
Tariff Barriers
Tariffs are taxes that are put in place not only to protect infant industries at home, but also
to prevent unemployment because of shut down of domestic industries. There are Ad
Valorem tariffs that are a ploy to keep imported goods pricier. This is done to protect
domestic producers of similar products.
Non Tariff Barriers
Placing tariff barriers are not enough to protect domestic industries, countries resort to non
tariff barriers that prevent foreign goods from coming inside the country.
One of these non tariff barriers is the creation of licenses. Companies are granted
licenses so that they can import goods and services. But enough restrictions are
imposed on new entrants so that there is less competition and very few companies
actually are able to import goods in certain categories. This keeps the amount of goods
imported under check and thus protects domestic producers.
Import Quotas is another trick used by countries to place a barrier to the entry of foreign
goods in certain categories. This allows a government to set a limit on the amount of
goods imported in a particular category. As soon as this limit is crossed, no importer can
import further quantities of the goods.
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Non tariff barriers are sometimes retaliatory in nature as when a country is antagonistic to
a particular country and does not wish to allow goods from that country to be imported.
There are instances where restrictions are placed on flimsy grounds such as when western
countries cite reasons of human rights or child labor on goods imported from third world
countries. They also place barriers to trade citing environmental reasons.
What is the difference between Tariff Barriers and non Tariff Barriers
The purpose of both tariff and non tariff barriers is same that is to impose
restriction on import but they differ in approach and manner.
Tariff barriers ensure revenue for a government but non tariff barriers do not bring
any revenue. Import Licenses and Import quotas are some of the non tariff
barriers.
Non tariff barriers are country specific and often based upon flimsy grounds that
can serve to sour relations between countries whereas tariff barriers are more
transparent in nature.

Trade Creation and Trade Diversion

Regional economic integration is only beneficial if the amount of trade it creates

exceeds the amount it diverts
trade creation occurs when low cost producers within the free trade area replace
high cost domestic producers
trade diversion occurs when higher cost suppliers within the free trade area
replace lower cost external suppliers

Trade Creation

This involves a shift in domestic consumer spending from a higher cost domestic
source to a lower cost partner source within the EU, as a result of the abolition tariffs
on intra-union trade. So for example UK households may switch their spending on car
and home insurance away from a higher-priced UK supplier towards a French
insurance company operating in the UK market.
Trade creation should stimulate an increase in trade within the customs union and
should, in theory, lead to an improvement in the efficient allocation of scarce resources
and gains in consumer and producer welfare.

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Trade Diversion

Trade diversion is best described as a shift in domestic consumer spending from a

lower cost world source to a higher cost partner source (e.g. from another country
within the EU-27) as a result of the elimination of tariffs on imports from the partner.
The common external tariff on many goods and services coming into the EU makes
imports more expensive. This can lead to higher costs for producers and higher prices
for consumers if previously they had access to a lower cost / lower price supply from a
non-EU country.
The overall effect of a customs union on the economic welfare of citizens in a country
depends on whether the customs union creates effects that are mainly trade creating
or trade diverting.

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Product Standardization vs Adaptation

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Page 564 - 569

Indices for Measuring the extent of MNEs Internationalisation
Transnationality Index - is the relationship between home and foreign activities for any
particular company. Thus a company is considered to be very internationalised if the ratio
of its foreign to domestic activities is very high, independently of whether those foreign
activities take place in one single foreign country or in many of them.
The Transnationality Index (TNI) is a means of ranking multinational corporations that is
employed by economists and politicians. It is calculated as the arithmetic mean of the
following three ratios (where "foreign" means outside of the corporation's home country):

the ratio of foreign assets to total assets

the ratio of foreign sales to total sales
the ratio of foreign employment to total employment

Internationalisation Index - Network Spread Index A different indicator of

internationalisation has been developed and values calculated in Vernon (1979). The
indicator assesses the overall spread of activities in terms of the number of countries in
which the TNCs have direct linkages (affiliates/subsidiaries). A company is therefore
assessed as having a high degree of internationalisation if it operates in many foreign
countries. It is an attempt to measure the overall geographical spread of TNCs subsidiaries
according to the number of countries/nations/states in which they are established.

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MANAGEMENT OF FOREIGN EXPOSURE

Exposure occurs because of unanticipated change in the exchange rate.

Types of exposures.
Accounting Exposures
Transaction Exposure
Translation Exposure
Operating / Economic Exposure

Economic Exposure
Economic exposure is the risk to the firm that its long-term cash flows will be affected,
positively or negatively, by unexpected future exchange rate changes.
It emphasizes that there is a limit to a firms ability to predict either cash flows or exchange
rate changes in the medium to long term.
Management of economic exposure is being prepared for the unexpected.
Translation exposure
Translation exposure is the risk that arises from the legal requirement that all firms
consolidate their financial statements of all worldwide operations annually.
Unlike transaction and economic exposures, which are true exposures, translation exposure
is an economic problem.
Transaction Exposure
Risk in adverse movement of exchange rates from the time the
transaction is budgeted till the time of exposure is extinguished by sale / purchase of a foreign
currency against domestic currency
The two conditions necessary for a transaction exposure to exist are:
1. A cash flow that is denominated in a foreign country.
2. The cash flow will occur at a future date.
Impact of Transaction Exposure.
It will be of short term in nature
Will have an impact on cash flow of a company
Managing transaction exposures
Managing transaction exposures usually is accomplished by either natural hedging or
contractual hedging.
Natural hedging describes how a firm might arrange to have foreign currency cash flows
coming in and going out at roughly the same times and same amounts.
Contractual hedging is when a firm uses financial contracts to hedge the transaction

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exposure. The most common foreign currency contractual hedge is the forward contract.
Hedging Transaction Exposure
Since exposure arises due to unanticipated movement of exchange rate , entering into a
financial counter-transaction at a future point in time is known as hedging
The amount receivable (exports) is technically referred as long position
The amount payable ( imports) is technically referred as short position
The basic rule of hedging is:
The payables (short position) in a currency in the future is to be hedged with buying (long
position) in the same currency in the forward; and receivables (long position) in a currency
in the future is to be hedged with selling (short position) the same currency in the forward

Instruments of Hedging

Forward contract
Money market hedge
Future contract
Option contract
Currency invoicing
Exposure netting
Currency Risk Sharing

Forward Contract
A forward contract is an agreement made today between a buyer and a seller to exchange the
commodity or instrument for cash at a predetermined future date at a price agreed upon today.
In a forward contract, two parties agree to do a trade at some future date, at a stated price and
quantity. No money changes hands at the time the deal is signed
Forward contracts are not traded on an exchange, they are said to trade over the counter
(OTC).
The secondary market do not exist for the forward contracts and faces the problem of liquidity

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and negotiability
Forward contracts face counter party risk
The longer the time period, larger is the counterparty risk

Hedging with Forward contract

Suppose an importer has imported a machine worth $ 1,00,000
The machine is expected to arrive in a month when the amount is payable
The current exchange rate is $1= Rs. 46.75
He expects to move the rate to $1= Rs. 47.75
He checks the forward market and finds that one month forward rate is $1= Rs. 47.50
The importer buys $1,00,000 as the dollar was cheaper in the forward market as compared to
his own perception

Money Market Hedge

Money market hedge involves mixing of foreign exchange and money markets to hedge at the
minimum cost
It involves taking advantage of disequilibrium between the two markets
One possibility: The importer buys that amount of dollars in the spot market which when
deposited in the US at US interest grows to $1,00,000 in one month
Second possibility:
The importer buys $1,00,000 in the forward market and to make the
payment in Indian rupees, deposits that much amount in the bank deposit to grow to honour the
contract

Futures Contract
A futures contract is a financial security, issued by an organised exchange to buy or sell a
commodity, security or currency at a predetermined future date at a price agreed upon today
Futures are exchange traded contracts to sell or buy financial instruments or physical
commodities for future delivery at an agreed price
The contract expires on a pre-specified date which is called the expiry date of the contract
On expiry, futures can be settled by delivery of the underlying asset or cash
The futures contract relates to a given quantity of the underlying asset and only whole
contracts can be traded

Currency Futures
Currency Futures means a standardised foreign exchange derivative contract traded on a
recognized stock exchange to buy or sell one currency against another on a specified future

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date, at a price specified on the date of contract

Currency future contracts allow investors to hedge against foreign exchange risk
Reserve Bank of India Act, 1934 permitted currency futures trading with effect from August 6,
2008.

Forwards Vs. Futures

Two parties negotiate a forward transaction

Futures is structured as two transactions

Difference between Forward Hedge and a Future Hedge

Forward Market Hedge

Future Hedge

Contracts executed by banks

Contracts executed by brokerage houses of

future exchanges

Tailor-made contracts

Standardised contracts

Price quoted reflects bankers perception of

future price

Price paid is determined by forces of demand

and supply

Contract bilateral between two parties

Contract with the future exchange

Options
An option is a contractual agreement that gives the option buyer the right, but not the
obligation, to purchase (call option) or to sell (put option) a specified instrument at a specified
price at any time of the option buyers choosing by or before a fixed date in the future
The buyer / holder of the option purchases the right from the seller/writer for a consideration
which is called the premium

Call Option :

A call option gives the buyer the right to buy a fixed number of

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shares/commodities at the exercise price upto the date of expiration of the contract
Put Option:
A put option gives the buyer the right to sell a fixed number of
shares/commodities at the exercise price upto the date of expiration of the contract

Options Example
Current price of oil is $65 per barrel. An airlines company feels oil prices might rise 6 months
later & wishes to hold an option to buy oil 6 months hence at, at most $67. An oil refinery feels
prices will fall 6 months later & wishes to hold an option to sell oil 6 months hence at, at least
$67. Both companies approach the exchange and place their orders.
Exchange has options which fulfill the requests at $67 per barrel.
1. What is the expiration period ?
2. Is Airline Company a holder or writer ?
3. Is Oil Refinery a holder or writer ?
4. What option type does Airline Company hold ?
5. What option type does Oil Refinery hold ?
6. What are the Strike Prices ?

Features of Options
The option is exercisable only by the owner, namely the buyer of the option
The owner has limited liability
Options have high degree of risk to the option writers Options involve buying counter positions
by the option sellers
Options are popular because they allow the buyer profits from favourable movements in
exchange rate

Option Benefits

Call

Put

Holder (Buyer who has gone Long)

Writer (Seller who has gone Short)

Right to Buy
No Obligation
Premium Pay
Right to Sell
No Obligation
Premium Pay

No Right
Obligation to Sell
Premium Receive
No Right
Obligation to Buy
Premium Receive

Hedging with Options

In the case of hedging with options, if the price surpass the expectations, only then the option

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is exercised and the hedge comes into operation.

This kind of hedging is usually resorted when there is a possibility of non-performance of
contract
The cost involved in purchasing an option is called premium

Hedge through Currency Invoicing

If during the negotiation of an import contract, an importer of a country having weak currency
may get goods invoiced in domestic currency and the exporter from this country should invoice
goods in strong currency
The risk shifts from one party to the other

MNCs and Transaction Exposure Management

The companies dealing in multicurrency environment or multicurrency cash flows need to
prepare cash budgets to know the exact extent of transaction exposure
The net transaction exposure is arrived at on quarterly basis
The net positive transaction exposure (+ ve flows) indicates strengthening of domestic currency
against foreign currency ($) will cause loss to the firm and depreciation makes it profitable
The net negative transaction exposure (- ve flows) indicates strengthening of domestic currency
against foreign currency ($) will give profit to the firm and weakening of domestic currency
would cause the loss
Hedging Transaction Exposure of MNCs
MNCs by nature are risk takers and they take risk when adequate compensation is present in
the venture
In a multicurrency environment, it is not necessary that foreign exchange risk to be zero for
international business to become attractive for the firm
Strategies to decrease transaction exposure:

International Diversification

Hedging

Countertrade
Countertrade is a sale that encompasses more than an exchange of goods, services, or ideas
for money.
Historically, countertrade was mainly conducted in the form of barter, which is a direct
exchange of goods of approximately equal value, with no money involved.
Conditions that encourage countertrade are:
lack of money,
lack of value of or faith in money,

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lack of acceptability of money as an exchange medium,

greater ease of transaction by using goods.

Reasons for Countertrade

Increasingly, countries and companies are deciding that sometimes countertrade transactions
are more beneficial than transactions based on financial exchange.
The use of countertrade permits the covert reduction of prices and therefore allows the
circumvention of price and exchange controls.
Many countries are responding favorably to the notion of bilateralism.
Countertrade is viewed as an excellent mechanism to gain entry into new markets.

FINANCIAL SWAPS

A swap is a derivative in which two counterparties exchange cash flows of one party's
financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. Specifically, two
counterparties agree to exchange one stream of cash flows against another stream. These
streams are called the legs of the swap. The swap agreement defines the dates when the
cash flows are to be paid and the way they are accrued and calculated.[1] Usually at the
time when the contract is initiated, at least one of these series of cash flows is determined
by an uncertain variable such as a floating interest rate, foreign exchange rate, equity
price, or commodity price.[1]
Interest Rate Swap
In the basic ("plain vanilla") fixed-for-floating rate interest rate swap, one counterparty
exchanges the interest payments of a floating-rate debt obligation for the fixed rate interest
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payments of the other counterparty. Both debt obligations are denominated in the same
currency.
Some reasons for using an interest rate swap are to better match cash inflows and
outflows and/or to obtain a cost savings. There are many variants of the basic interest rate
swap, some of which are discussed below.
The diagram below is an example of a fixed-for-floating interest-rate swap:

Counterparty A (the Investment Bank) is said to swap a fixed-interest payment to

Counterparty B (the Pension Fund) for a floating-rate interest payment. Over the life of the
swap, the Pension Fund will pay the Investment Bank a floating rate and receive a fixed
rate of interest in return.
Currency Swap
In a currency swap, one counterparty exchanges the debt service obligations of a bond
denominated in one currency for the debt service obligations of the other counterparty
denominated in another currency. The basic currency swap involves the exchange of
fixed-for-fixed rate debt service.
Some reasons for using currency swaps are to obtain debt financing in the swapped
denomination at a cost savings and/or to hedge long-term foreign exchange rate risk.

Hedging
A hedge is an investment position intended to offset potential losses/gains that may be
incurred by a companion investment. In simple language, a hedge is used to reduce any
substantial losses/gains suffered by an individual or an organization.
A hedge can be constructed from many types of financial instruments, including stocks,
exchange-traded funds, insurance, forward contracts, swaps, options, many types of overthe-counter and derivative products, and futures contracts.
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'Arbitrage' The simultaneous purchase and sale of an asset in order to profit from a
difference in the price. It is a trade that profits by exploiting price differences of identical or
similar financial instruments, on different markets or in different forms.
'Cross Rate' The currency exchange rate between two currencies, both of which are not
the official currencies of the country in which the exchange rate quote is given in.

__________________________________ Managing Multinationals - Executive MBA - Semester IV