Lectures International & Strategic risk Management
Lecture 1 3 February 2020
Chapter 1: Globalization & Multinational Firm
Theory of Comparative Advantage
• David Ricardo (1772-1823) challenged mercantilism, promoted free trade.
• Mercantilism: a nation’s wealth is built by precious metals; high import tariffs, subsidize
export; protect trade route, expand colonies.
• Frequent wars among the countries.
• A comparative advantage exists when one party can produce a good or service at a lower
opportunity cost than another party.
• The opportunity cost of making one additional unit of a good (or service) can be defined as the
value of some other good that you have to give up in order to produce this additional unit.
• For example, if you can work as many hours as you like at your current employer and get paid
$10 per hour, then the opportunity cost of your leisure is $10 per hour.
• Opportunity Cost ≠ Input.
• Opportunity cost = value of some other good that you have to give up in order to produce this
additional unit.
Comparative Advantage: Example
• Suppose there are two countries, A and B, who can each produce only food and textiles.
• Each country has 60 units of available ‘input’.
- For A, 1 unit of input gives 3 units textiles or 5 units food.
- For B, 1 unit of input gives 4 units textiles or 15 units food.
• The opportunity cost of producing food or textiles is different for A than B.
• A: opportunity cost for textile = 5/3(so how much food you give up for one unit of textile is
5/3); food = 3/5.
B: opportunity cost for textile = 15/4; food = 4/15.
County A: No Trade
• Production possibilities curve shows the output a
country can generate.
• 100% in production of textiles would yield 180 million
yards of textiles.
• 100% in production of food would yield 300 million
pounds of food.
Country B: No Trade
• 100% in production of textiles would yield 240 million
yards of textiles.
• 100% in the production of food would yield 900
million pounds of food.
Source of Comparative Advantage
• Country A has a comparative advantage in textiles
because they have to give up food at a lower rate than
B when making textiles.
• Country B has a comparative advantage in food
because they have to give up textiles at a lower rate
than A when making more food.
Total Production (Consumption) without Trade
• A: textile = 300/180 = 1.67 Food = 180/300 = 0.6
• B: textile = 900/240 = 3.75 Food = 240/900 = 0.26
, • A has a lower opportunity cost for textile (compared to B) and B has a lower opportunity cost
for food (so preferred to produce food) → focus on the lowest opportunity cost, the country
with the lowest opportunity cost produces the product.
• Combined production line with trade is always higher than without trade.
• More international trade does lead to potential risks → need to handle those risks.
Economic Integration
• Over the past 50 years, international trade increased about twice as fast as world GDP.
• Change in the attitude of many governments, who have abandoned mercantilist views and
embraced free trade as the surest route to prosperity for their citizens.
Liberalization of Protectionist Legislation
• The General Agreement on Tariffs and Trade (GATT, 1947) is a multilateral agreement among
member countries that has reduced many barriers to trade.
• The World Trade Organization (1995 has the power to enforce the rules of international trade.
• Average tariff reduction for major participating countries: from 22% in 1947 to 5% in 1999.
Money: Origin, Value and Risk
• Money is perhaps the most basic building-block in economics.
- A medium of exchange, easily traded for goods and services, reduce barter costs.
- A store of value, so that it can be saved and used for consumption in the future.
- A unit of account, a useful measuring-stick.
• Examples: metals; tea bricks; shower-gel capsules; squirrel fur.
State Theory of Money
• Governments (authorities) need to collect taxes.
- A measuring stick of economic activities (incomes and expenditures) and tax them.
- A convenient way to collect and manage the wealth.
- Boost the wealth (from the difference between the mintage cost and value of the money),
or seigniorage (= e.g. costs to print a €10 bill is €0.05, then the seigniorage is €9.95).
• Result: exclusive right of governments to issue currencies (legal tenders); adoption of precious
metals, the value of a currency (rate of exchange) is regulated.
Commodity Money vs Fiat Money
• Commodity: value of money is supported by
an intrinsic value (a precious medal, for
example gold).
• Fiat money: something the government says
you can use to pay for taxes (because there
was not enough intrinsic gold anymore).
Practice
• What could be a currency? glass marbles;
clothes; bananas; spices; crypto tokens.
• We would expect a currency: reduces barter costs; should not lose value when it is bought and
sold; is divisible into smaller pieces if needed (sale ableness).
Risk Dimensions
• Foreign Exchange Risk: foreign currency profits may evaporate due to unanticipated
unfavourable exchange rate movements.
, - Example 1: Suppose $1 = ¥100, and you buy 10 shares of Toyota at ¥10,000 per share with
your $1000. One year later the investment is worth ten percent more in yen: ¥110,000.
If the yen has depreciated to $1 = ¥120 in one year → your investment has lost money in
dollar terms (now it is $916,67).
- Example 2: You plan to export 100 machine tools from Netherlands to UK for a total
revenue of GBP100,000. At the time you signed the agreement 1 EURO was equal in value
to 1 GBP.
But now, say, 1 EURO is worth 2 GBP. You are now getting EURO 50,000! (not 100,000)
• Political risk: sovereign governments have the right to regulate the movement of goods,
capital and people across their borders. These laws sometimes change in unexpected ways.
Around election year there may be some political unrest, especially in countries where the
outcome is uncertain. This may lead to volatile exchange rate.
Market Dimensions
• Market imperfections: legal restrictions on the movement of goods, people and money;
transaction costs; shipping costs; tax arbitrage.
- Arbitrage: simultaneous purchase and sale of an asset in order to profit from a difference
in the price.
- Tax arbitrage: multinational companies (MNC) can reduce their global tax burden by
shifting profits from units located in high-tax countries to those in lower-tax countries.
MNCs exist to take advantage of market imperfections.
• Expanded opportunity set: more advantageous financing, investment, production possibilities
(‘It doesn’t make sense to play in only one corner of the sandbox’); firms can gain from greater
economies of scale when their assets are deployed on a global basis; true for individual
investors as well as corporations.
Globalization of the World Economy
• Integration of the world’s nations and the process by which that integration occurs.
• What is the real cause of globalization?: technological advances in communication and
transportation.
• What is the implication?: we can better take advantage of a greater range of markets to which
we can sell our goods or from which we can purchase our supplies.
Lecture 2 6 February 2020
Chapter 2: The International Monetary System
Risk in Value of Money
• When money/currency is well-adopted for transactions (to reduce the barter cost) risk in the
value of money is added to the transactions.
- Purchase power of money.
- Inflation: value of money decreases.
- Deflation: get more services for the same amount of money.
• Irving Fisher’s Equation of Exchange: M*V = P*Q
- M: total amount of money in circulation.
- V: how fast money is spent.
- P: price level.
- Q: real expenditures.
• Hyperinflation: e.g. today €2 coffee, tomorrow €10 coffee.
• If price label goes down, people do not want to spend yet but wait for an even lower price →
less products sold → less employees needed → lower incomes.
• Goal: keep inflation percentage at 2% per year, value of currency goes down a bit, to stimulate
production because people are going to spend.
The Value of Money
• By State Theory of Money, governments play an important role in the development of
money/currencies. Government wants the value of money to stay stable.
, - Adopt precious metals to provide intrinsic values (commodity money).
- Governments may not have sufficient precious metals to mint all the money needed for all
the economic activities in their territories.
o Un-restricted mintage (free coinage).
o Bimetallism: could bring gold or silver to convert into a coin.
- Value stabilizing mechanism – if the country’s economic activities (demand) and supply of
precious metals are stable.
- Example: Spanish price revolution in the 16th century.
Story of Sir Isaac Newton
• 13 years after the publication of Principia (about laws of motion) he assumed Master of Royal
Mint in 1700.
• Convicting at least 28-coin counterfeiters.
• GB was in silver standard before introduction of gold coin “guinea” in 1663 → Bimetallism.
• In 1717, Newton suggested the official exchange rate to be 1:15.5 (or 2:21).
• Gresham's law (1558): “Bad” money drives out “good” money.
- Bad money (e.g. paper cash): overvalued money, cheaper.
- Good money: undervalued money, actual value is higher than nominal
→ people want to keep it.
• GB moved toward her first gold standard era.
Classical Gold Standard: 1875 - 1914
• During this period in most major countries: gold alone was assured of unrestricted coinage;
there was two-way convertibility between gold and national currencies at a stable ratio; gold
could be freely exported or imported.
• The exchange rate between two country’s currencies would be determined by their relative
gold contents. Banknotes (arose in mid-17th century) need to be backed by a gold reserve of a
minimum stated ratio.
• Domestic money stock should rise and fall as gold flows in and out of the country.
Classical Gold Standard: example
• Rules of the game:
- Rule 1: Set a rate at which the currency can be exchanged with gold.
- Rule 2: Credibly maintain adequate reserves of gold.
• Example: The dollar is pegged to gold at U.S. $30 = 1 ounce (28.3 gr) of gold, and the British
pound is pegged to gold at £6 = 1 ounce of gold. The exchange rate is determined by the
relative gold contents:
- $30 = 1 ounce of gold = £6
- $30 = £6
- $5 = £1
Price-Specie-Flow Mechanism
• Suppose Great Britain exports more to France than France imports from Great Britain.
• This cannot persist under a gold standard:
- Net export of goods from Great Britain to France will be accompanied by a net flow of
gold from France to Great Britain.
- This flow of gold will lead to a lower price level in France and, at the same time, a higher
price level in Britain.
• The resultant change in relative price levels will slow exports from Great Britain and
encourage imports from France.
• Built-in mechanism to balance trade!
Moving from Commodity Money to Fiat Money
• The Fall of Gold Standard: GB (1931), US (1933), France (1936). Golden standard cannot be
used anymore because there’s too much trade.
• The flow of capital brings comparable impact with the flow of goods. Gold may flow out of a
country with a trade surplus.
