# The Importance of Trade Credit and Working Capital in Planning

## Using Excel to Create the Short-Term Plan

By the end of this section, you will be able to:
1. Create a one-year budget.
2. Create a cash budget.
A cash budget is a tool of cash management and therefore assists financial managers in the planning and control of a critical asset. The cash budget, like any other budget, looks to the future. It projects the cash flows into and out of the company. The budgeting process of a company is a really an integrated process—it links a series of budgets together so that company objectives can be achieved. For example, in a manufacturing company, a series of budgets such as those for sales, production, purchases, materials, overhead, selling and administrative costs, and planned capital expenditures would need to be prepared before cash needs (cash budget) can be predicted.
Just as you might budget your earnings (salary, business income, investment income, etc.) to see if you will be able to cover your expected living expenses and planned savings amounts, to be successful and to increase the odds that sufficient cash will be available in the months ahead, financial managers prepare cash budgets to
1. meet payrolls;
2. allocate dollars for contingencies and emergencies;
3. analyze if planned collections and disbursements policies and procedures result in adequate cash balances; and
4. plan for borrowings on lines of credit and short-term loans that might be needed to balance the cash budget.
A cash budget is a model that often goes through several iterations before managers can approve it as the plan going forward. Changes in any of the “upstream” budgets—budgets that are prepared before the cash budget, such as the sales, purchases, and production budgets—may need to be revised because of changing assumptions. New economic forecasts and even cost-cutting measures will require a revision of the cash budget.
Although a budget might be prepared for each month of a future 12-month period, such as the upcoming fiscal year, a rolling budget is often used. A rolling budget changes often as the planning period (e.g., a fiscal year) plays out. When one month ends, another month is added to the end (the next column) of the budget. For example, if in your budget January is the first month of the planning period, once January is over, next January’s cash budget column would be added—right after December’s column (at the far right of the budget).

### Sample One-Year (Annual) Operating Budget

Preparing an annual operating budget can be a complex task. In essence, a company budget is a series of budgets, many of which are interrelated.
The sales budget is prepared first and has an impact on many other budgets. Take the example of a production budget of a manufacturer. The sales budget impacts what needs to be produced (production budget), and the production budget influences planned purchases of material (purchases budget), overhead resources (overhead budget), and the amount of labor costs for the year ahead (direct labor budget.)
For a merchant (such as a wholesaler or retailer), the annual budget would be less complex than that of a manufacturing firm but would still require an inventory purchases budget and an operating expense budget (such as selling and administrative expenses). For a service firm, a purchase budget for inventory would not be necessary, but an operating budget would be. All businesses need a cash budget, which is the topic of the next section of this chapter.
The example operating budget presented here is of a merchandising company. Budgets are prepared following a process that begins with a sales (or revenue) forecast. The sales forecast is normally based on information obtained from both internal and external sources and predicts the amount of units to be sold in the planning period—usually one year into the future.
A company’s management, in consultation with its marketing and sales executives, would prepare a sales budget by making assumptions about the number of units that are expected to be sold and the prices that will be charged. From the sales budget, projections are made as to cash receipts each month, and therefore assumptions have to be made as to how much of each month’s sales will be cash sales and how much cash will flow into the company from the collection credit sales (including cash flow in from the prior month’s sales).  provides an example of a sales budget and projected accounts receivable collections and cash sales for the months of January through December. Keep in mind that projected monthly sales amounts are not equal to cash collected from sales. Because of sales on credit, some cash from sales lags credit sales as collections can extend beyond the month of sale. Credit terms such terms such as net 30 (net amount owed to be paid in 30 days) have to be considered when developing a forecasted cash collection pattern.
Sales budgets “drive” the preparation of other budgets. If sales are expected to increase, purchases of inventory and some operating expenses would also increase. To meet the demand for goods and services (as defined in the sales budget), a purchases (inventory) budget would be prepared. In this example (), the purchases budget shows projected purchases of inventory (merchandise) and the projected payments (also called disbursements) for each month.
Cash outflows as a result of purchases often do not equal the projected purchase amount. That is because payments for purchases are usually on credit (accounts payable), and so purchases for one month typically get spread out over a period of time that encompasses the current month and the month (or months) thereafter. To keep this example simple, the assumption is that the purchases are paid for in the following month (an average days payable outstanding of 30 days). However, in other cases, payment patterns may be based on other payment periods such as 45, 60, or even 90 days, depending on the trade credit terms.
An operating expense budget is prepared next and is basically a prediction of the selling and administrative expenditures of the company. Notice in  that in the operating expense budget, cost of goods sold (an expense) is not included, nor are noncash expenses such as depreciation. The cash outlays related to goods sold, at least in a merchandising operation, are accounted for in the purchases budget (payments for purchases of inventory.)
With the sales, purchases, and operating expense budgets prepared, the cash budget can be prepared. Some of the “inputs” to the cash budget are from the sales (collections of cash), purchases (payments), and the operating expense budget (cash expenditures for selling and administrative expenses). A sample cash budget and a discussion of its preparation follows in the next section of this chapter.

### Sample Cash Budget

A cash budget is the last budget to be prepared and is often part of the financial budget (cash budget, budgeted income statement, and budgeted balance sheet). The purpose of the cash budget is to estimate cash flows, to help ensure sufficient cash balances are maintained during the planning period, and to plan for external financing during periods of cash deficits.
When a budget is prepared in Excel, cash budget analysts can play “what if” with different scenarios to see when cash surpluses and deficits are expected. Cash surpluses means that funds can be invested in marketable securities to earn a rate of return, while cash deficits mean that financing, such as a line of credit, will be necessary (assuming forecasts are accurate).
Although the example shown in  is a monthly cash budget, a cash budget could be prepared using any useful time elements: weekly, monthly, or quarterly.
One common practice is to use a rolling cash budget. A rolling cash budget is continually updated to add a new budget period, such as a month’s amount of cash flow activity, as the most recent budgeted month expires. For example, assume that a 12-month cash budget is prepared for a period covering January 20X1 to December 20X1. Once the month of January 20X1 has concluded, a 12-month planning period continues by add January 20X2 to the last column of the budget. The rolling cash monthly budget is an extension of the initial cash budget model, adding one month and thereby always extending cash flow projections one year into the future.
Using  as an example,  shows the formulas that form the skeleton of a monthly cash budget.

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Short-term plans of a business are funded with cash, with cash budgets being a critical tool of planning. The cash budget takes into account a target amount of cash, factoring in all the motives for holding cash. A cash budget looks ahead—predicting cash inflows and outflows, allocating for minimum cash balances to be maintained, and helping management determine short-term financing needed. Although it is the last budget prepared, the preparation of the cash budget is an important financial planning exercise of companies small and large.

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# Risk Management and the Financial Manager

## Why It Matters

Each year, American Airlines consumes approximately four billion gallons of jet fuel.American Airlines.  In the spring of 2018, jet fuel prices rose from an average of $2.07 per gallon to a price of $2.19 per gallon.S&P Global. “Platts Jet Fuel.”  A $0.12-per-gallon increase in the price of jet fuel may not seem significant, but on an annualized basis, a price increase of this magnitude would increase the company’s jet fuel bill by approximately $500 million.
That added cost cuts into the profits of the company, leaving less money available to provide a return to the company’s investors. Rising costs could even cause the business to become unprofitable and close, causing many employees to lose their jobs. The financial managers of American Airlines are not able to control the price of jet fuel. However, they must be aware of the risk that price volatility poses to the company and consider prudent ways to manage this risk.


# Risk Management and the Financial Manager

## The Importance of Risk Management

### Learning Outcomes

By the end of this section, you will be able to:
1. Describe risk in the context of financial management.
2. Explain how risk can impact firm value.
3. Distinguish between hedging and speculating.

### What Is Risk?

The job of the financial manager is to maximize the value of the firm for the owners, or shareholders, of the company. The three major areas of focus for the financial manager are the size, the timing, and the riskiness of the cash flows of the company. Broadly, the financial manager should work to
1. increase cash coming into the company and decrease cash going out of the company;
2. speed up cash coming into the company and slow down cash going out of the company; and
3. decrease the riskiness of both money coming in and money going out of the company.
The first item in this list is obvious. The more revenue a company has, the more profitable it will be. Businesspeople talk about “top line” growth when discussing this objective because revenue appears at the top of the company’s income statement. Also, the lower the company’s expenses, the more profitable the company will be. When businesspeople talk about the “bottom line,” they are focused on what will happen to a company’s net income. The net income appears at the bottom of the income statement and reflects the amount of revenue left over after all of the company’s expenses have been paid.
The second item in the list—the speed at which money enters and exits the company—has been addressed throughout this book. One of the basic principles of finance is the time value of money—the idea that a dollar received today is more valuable than a dollar received tomorrow. Many of the topics explored in this book revolve around the issue of the time value of money.
The focus of this chapter is on the third item in the list: risk. In finance, risk is defined as uncertainty. Risk occurs because you cannot predict the future. Compared to other business decisions, financial decisions are generally associated with contracts in which the parties of the contract fulfill their obligations at different points in time. If you choose to purchase a loaf of bread, you pay the baker for the bread as you receive the bread; no future obligation arises for either you or the baker because of this purchase. If you choose to buy a bond, you pay the issuer of the bond money today, and in return, the issuer promises to pay you money in the future. The value of this bond depends on the likelihood that the promise will be fulfilled.
Because financial agreements often represent promises of future payment, they entail risk. Even if the party that is promising to make a payment in the future is ethical and has every intention of honoring the promise, things can happen that can make it impossible for them to do so. Thus, much of financial management hinges on managing this risk.

### Risk and Firm Value

You would expect the managers of Starbucks Corporation to know a lot about coffee. They must also know a lot about risk. It is not surprising that the term coffee appears in the text of the company’s 2020 annual report 179 times, given that the company’s core business is coffee. It might be surprising, however, that the term risk appears in the report 99 times.Starbucks.  Given that the text of the annual report is less than 100 pages long, the word risk appears, on average, more than once per page.
Starbucks faces a number of different types of risk. In 2020, corporations experienced an unprecedented risk because of COVID-19. Coffee shops were forced to remain closed as communities experienced government-mandated lockdowns. Locations that were able to service customers through drive-up windows were not immune to declining revenue due to the pandemic. As fewer people gathered in the workplace, Starbucks experienced a declining number of to-go orders from meeting attendees. In addition, Starbucks locations faced the risk of illness spreading as baristas gathered in their buildings to fill to-go orders.
While COVID-19 brought discussions of risk to the forefront of everyday conversations, risk was an important focus of companies such as Starbucks before the pandemic began. (The term risk appeared in the company’s 2019 annual report 82 times.Starbucks. ) Starbucks’s business model revolves around turning coffee beans into a pleasurable drink. Anything that impacts the company’s ability to procure coffee beans, produce a drink, and sell that drink to the customer will impact the company’s profitability.
The investors in the company have allowed Starbucks to use its capital to lease storefronts, purchase espresso machines, and obtain all of the assets necessary for the company to operate. Debt holders expect interest to be paid and their principal to be returned. Stockholders expect a return on their investment. Because investors are risk averse, the riskier they perceive the cash flows they will receive from the business to be, the higher the expected return they will require to let the company use their money. This required return is a cost of doing business. Thus, the riskier the cash flows of a company, the higher the cost of obtaining capital. As any cost of operating a business increases, the value of the firm declines.
In the following sections, you will learn about some of the types of risk that firms commonly face. You will also learn about ways in which firms can reduce their exposure to these risks. When firms take actions to reduce their exposures to risk, they are said to be hedging. Firms hedge to try to protect themselves from losses. Thus, in finance, hedging is a risk management tool.
Certain strategies are commonly used by firms to hedge risk, which is part of corporate financial management. Many of these same strategies can be used by economic players who wish to speculate. Speculating occurs when someone bets on a future outcome. It involves trying to predict the future and profit off of that prediction, knowing that there is some risk that an incorrect prediction will lead to a loss. Speculators bet on the future direction of an asset price. Thus, speculation involves directional bets.
If you are concerned that the price of hand sanitizer is going to rise because people are concerned about a new virus and you purchase a few extra bottles to keep on your shelf “just in case,” you are hedging. If you see this situation as a business opportunity and purchase bottles of hand sanitizer, hoping that you can sell them on eBay in a few weeks at twice what you paid for them, you are speculating.
In the popular press, you will often hear of some of the strategies in this chapter discussed in terms of people using them to speculate. In upper-level finance courses, these strategies are discussed in more depth, including how they might be used to speculate. In this chapter, however, the focus is on the perspective of a financial manager using these strategies to manage risk.

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Risk arises due to uncertainty. The future is unpredictable. One job of the financial manager is to manage the risks of both cash inflows and cash outflows. Investors are risk-averse. The riskier a firm’s cash flows are, the higher the rate of return investors require to provide capital to the company.

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# Risk Management and the Financial Manager

## Commodity Price Risk

### Learning Outcomes

By the end of this section, you will be able to:
1. Describe commodity price risk.
2. Explain the use of long-term contracts as a hedge.
3. Explain the use vertical integration as a hedge.
4. Explain the use of futures contracts as a hedge.
One of the most significant risks that many companies face arises from normal business operations. Companies purchase raw materials to produce the products and provide the services they sell. A change in the market price of these raw materials can significantly impact the profitability of a company.
For example, Starbucks must purchase coffee beans in order to make its coffee drinks. The price of coffee beans is highly volatile. Sample prices of a pound of Arabica coffee beans over the past couple of decades are shown in . Over this period, the price of coffee beans ranged from a low of $0.52 per pound in the summer of 2002 to a high of over $3.00 per pound in the spring of 2011. The costs, and thus the profits, of Starbucks will vary greatly depending on if the company is paying less than $1.00 per pound for coffee or if it is paying three times that much.

### Long-Term Contracts

One method of hedging the risk of volatile input prices is for a firm to enter into long-term contracts with its suppliers. Starbucks, for example, could enter into an agreement with a coffee farmer to purchase a particular quantity of coffee beans at a predetermined price over the next several years.
These long-term contracts can benefit both the buyer and the seller. The buyer is concerned that rising commodity prices will increase its cost of goods sold. The seller, however, is concerned that falling commodity prices will mean lower revenue. By entering into a long-term contract, the buyer is able to lock in a price for its raw materials and the seller is able to lock in its sales price. Thus, both parties are able to reduce uncertainty.
While long-term contracts reduce uncertainty about the commodity price, and thus reduce risk, there are several possible disadvantages to these types of contracts. First, both parties are exposed to the risk that the other party may default and fail to live up to the terms of the contract. Second, these contracts cannot be entered into anonymously; the parties to the contract know each other’s identity. This lack of anonymity may have strategic disadvantages for some firms. Third, the value of this contract cannot be easily determined, making it difficult to track gains and losses. Fourth, canceling the contract may be difficult or even impossible.

### Vertical Integration

A common method of handling the risk associated with volatile input prices is vertical integration, which involves the merger of a company and its supplier. For Starbucks, a vertical integration would involve Starbucks owning a coffee bean farm. If the price of coffee beans rises, the firm’s costs increase and the supplier’s revenues rise. The two companies can offset these risks by merging.
Although vertical integration can reduce commodity price risk, it is not a perfect hedge. Starbucks may decrease its commodity price risk by purchasing a coffee farm, but that action may expose it to other risks, such as land ownership and employment risk.

### Futures Contracts

Another method of hedging commodity price risk is the use of a futures contract. A commodity futures contract is designed to avoid some of the disadvantages of entering into a long-term contract with a supplier. A futures contract is an agreement to trade an asset on some future date at a price locked in today. Futures exist for a range of commodities, including natural resources such as oil, natural gas, coal, silver, and gold and agricultural products such as soybeans, corn, wheat, rice, sugar, and cocoa.
Futures contracts are traded anonymously on an exchange; the market price is publicly observable, and the market is highly liquid. The company can get out of the contract at any time by selling it to a third party at the current market price.
A futures contract does not have the credit risk that a long-term contract has. Futures exchanges require traders to post margin when buying or selling commodities futures contracts. The margin, or collateral, serves as a guarantee that traders will honor their obligations. Additionally, through a procedure known as marking to market, cash flows are exchanged daily rather than only at the end of the contract. Because gains and losses are computed each day based on the change in the price of the futures contract, there is not the same risk as with a long-term contract that the counterparty to the contract will not be able to fulfill their obligation.

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Companies do not know how much they will have to pay for raw materials in future months. The price of raw materials will change as economic conditions change, impacting a company’s cost of goods sold and profits. Some ways that a company can hedge this risk are through vertical integration, long-term contracts, and futures contracts.

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### Hedging at Southwest Airlines

Jet fuel costs represent a major expense for airlines. Southwest Airlines has been known as the most aggressive airline when it comes to hedging the risk of jet fuel cost volatility. In this interview, the CEO of Southwest Airlines, Gary Kelly, discusses crude oil prices in the spring of 2012 and the impact on Southwest Airlines.


# Risk Management and the Financial Manager

## Exchange Rates and Risk

### Learning Outcomes

By the end of this section, you will be able to:
1. Describe exchange rate risk.
2. Identify transaction, translation, and economic risks.
3. Describe a natural hedge.
4. Explain the use of forward contracts as a hedge.
5. List the characteristics of an option contract.
6. Describe the payoff to the holder and writer of a call option.
7. Describe the payoff to the holder and writer of a put option.
The managers of companies that operate in the global marketplace face additional complications when managing the riskiness of their cash flows compared to domestic companies. Managers must be aware of differing business climates and customs and operate under multiple legal systems. Often, business must be conducted in multiple languages. Geopolitical events can impact business relationships. In addition, the company may receive cash flows and make payments in multiple currencies.

### Exchange Rates

The costs to companies are impacted when the prices of the raw materials they use change. Very little coffee is grown in the United States. This means that all of those coffee beans that Starbucks uses in its espresso machines in Seattle, New York, Miami, and Houston were bought from suppliers outside of the United States. Brazil is the largest coffee-producing country, exporting about one-third of the world’s coffee.Global Agricultural Information Network.  When a company purchases raw materials from a supplier in another country, the company needs not just money but the money that is used in that country to make the purchase. Thus, the company is concerned about the exchange rate, or the price of the foreign currency.
The currency used in Brazil is called the Brazilian real.  shows how many Brazilian reals could be purchased for $1.00 from 2010 through the first quarter of 2021. In March 2021, 5.4377 Brazilian reals could be purchased for $1.00. This will often be written in the form of
BRL is an abbreviation for Brazilian real, and USD is an abbreviation for the US dollar. This price is known as a currency exchange rate, or the rate at which you can exchange one currency for another currency.
If you know the price of $1.00 is 5.4377 Brazilian reals, you can easily find the price of Brazilian reals in US dollars. Simply divide both sides of the equation by 5.4377, or the price of the US dollar:
If you have US dollars and want to purchase Brazilian reals, it will cost you $0.1839 for each Brazilian real you want to buy.
The foreign exchange rate changes in response to demand for and supply of the currency. In early 2020, the exchange rate was . In other words, $1 purchased fewer reals in early 2020 than in it did a year later. Because you receive more reals for each dollar in 2021 than you would have a year earlier, the dollar is said to have appreciated relative to the Brazilian real. Likewise, because it takes more Brazilian reals to purchase $1.00, the real is said to have depreciated relative to the US dollar.

### Exchange Rate Risks

Starbucks, like other firms that are engaged in international business, faces currency exchange rate risk. Changes in exchange rates can impact a business in several ways. These risks are often classified as transaction, translation, or economic risk.

### Transaction Risk

Transaction risk is the risk that the value of a business’s expected receipts or expenses will change as a result of a change in currency exchange rates. If Starbucks agrees to pay a Brazilian coffee grower seven million Brazilian reals for an order of one million pounds of coffee beans, Starbucks will need to purchase Brazilian reals to pay the bill. How much it will cost Starbucks to purchase these Brazilian reals depends on the exchange rate at the time Starbucks makes the purchase.
In March 2021, with an exchange rate of , it would have cost Starbucks  to purchase the reals needed to receive the one million pounds of coffee beans. If, however, Starbucks agreed in March to purchase the coffee beans several months later, in July, Starbucks would not have known then what the exchange rate would be when it came time to complete the transaction. Although Starbucks would have locked in a price of BRL 7,000,000 for one million pounds of coffee beans, it would not have known what the coffee beans would cost the company in terms of US dollars.
If the US dollar appreciated so that it cost less to purchase each Brazilian real in July, Starbucks would find that it was paying less than $1,287,300 for the coffee beans. For example, suppose the dollar appreciated so that the exchange rate was  in July 2021. Then the coffee beans would only cost Starbucks .
On the other hand, if the US dollar depreciated and it cost more to purchase each Brazilian real, then Starbucks would find that its dollar cost for the coffee beans was higher than it expected. If the US dollar depreciated (and the Brazilian real appreciated) so that the exchange rate was  in July 2021, then the coffee beans would cost Starbucks . This uncertainty regarding the dollar cost of the coffee beans Starbucks would purchase to make its lattes is an example of transaction risk.
A global company such as Starbucks has transaction risk not only because it is purchasing raw materials in foreign countries but also because it is selling its product—and thus collecting revenue—in foreign countries. Customers in Japan, for example, spend Japanese yen when they purchase a Starbucks cappuccino, coffee mug, or bag of coffee beans. Starbucks must then convert these Japanese yen to US dollars to pay the expenses that it incurs in the United States to produce and distribute these products.
The Japanese yen–US dollar foreign exchange rates from 2011 through the first quarter of 2021 are shown in . In 2012, $1.00 could be purchased with fewer than 80 Japanese yen. In 2015, it took over 120 yen to purchase $1.00.
If a company is receiving yen from customers and paying expenses in dollars, the company is harmed when the yen depreciates relative to the dollar, meaning that the yen the company receives from its customers can be exchanged for fewer dollars. Conversely, when the yen appreciates, it takes fewer yen to purchase each dollar; this appreciation of the yen benefits companies with revenues in yen and expenses in dollars.

### Translation Risk

In addition to the transaction risk, if Starbucks holds assets in a foreign country, it faces translation risk. Translation risk is an accounting risk. Starbucks might purchase a coffee plantation in Costa Rica for 120 million Costa Rican colones. This land is an asset for Starbucks, and as such, the value of it should appear on the company’s balance sheet.
The balance sheet for Starbucks is created using US dollar values. Thus, the value of the coffee plantation has to be translated to dollars. Because exchange rates are volatile, the dollar value of the asset will vary depending on the day on which the translation takes place. If the exchange rate is 500 colones to the dollar, then this coffee plantation is an asset with a value of $240,000. If the Costa Rican colón depreciates to 600 colones to the dollar, then the asset has a value of only $200,000 when translated using this exchange rate.
Although it is the same piece of land with the same productive capacity, the value of the asset, as reported on the balance sheet, falls as the Costa Rican colón depreciates. This decrease in the value of the company’s assets must be offset by a decrease in the stockholders’ equity for the balance sheet to balance. The loss is due simply to changes in exchange rates and not the underlying profitability of the company.

### Economic Risk

Economic risk is the risk that a change in exchange rates will impact a business’s number of customers or its sales. Even a company that is not involved in international transactions can face this type of risk. Consider a company located in Mississippi that makes shirts using 100% US-grown cotton. All of the shirts are made in the United States and sold to retail outlets in the United States. Thus, all of the company’s expenses and revenues are in US dollars, and the company holds no assets outside of the United States.
Although this firm has no financial transactions involving international currency, it can be impacted by changes in exchange rates. Suppose the US dollar strengthens relative to the Vietnamese dong. This will allow US retail outlets to purchase more Vietnamese dong, and thus more shirts from Vietnamese suppliers, for the same amount of US dollars. Because of this, the retail outlets experience a drop in the cost of procuring the Vietnamese shirts relative to the shirts produced by the firm in Mississippi. The Mississippi company will lose some of its customers to these Vietnamese producers simply because of a change in the exchange rate.

### Hedging

Just as companies may practice hedging techniques to reduce their commodity risk exposure, they may choose to hedge to reduce their currency risk exposure. The types of futures contracts that we discussed earlier in this chapter exist for currencies as well as for commodities. A company that knows that it will need Korean won later this year to purchase raw materials from a South Korean supplier, for example, can purchase a futures contract for Korean won.
While futures contracts allow companies to lock in prices today for a future commitment, these contracts are not flexible enough to meet the risk management needs of all companies. Futures contracts are standardized contracts. This means that the contracts have set sizes and maturity dates. Futures contracts for Korean won, for example, have a contract size of 125 million won. A company that needs 200 million won later this year would need to either purchase one futures contract, hedging only a portion of its needs, or purchase two futures contracts, hedging more than it needs. Either way, the company has remaining currency risk.
In this next section, we will explore some additional hedging techniques.

### Forward Contracts

Suppose a company needs access to 200 million Korean won on March 1. In addition to a specified contract size, currency futures contracts have specified days on which the contracts are settled. For most currency futures contracts, this occurs on the third Wednesday of the month. If the company needed 125 million Korean won (the basic contract size) on the third Wednesday of March (the standard settlement date), the futures contract could be useful. Because the company needs a different number of Korean won on a different date from those specified in the standard contract, the futures contract is not going to meet the specific risk management needs of the company.
Another type of contract, the forward contract, can be used by this company to meet its specific needs. A forward contract is simply a contractual agreement between two parties to exchange a specified amount of currencies at a future date. A company can approach its bank, for example, saying that it will need to purchase 200 million Korean won on March 1. The bank will quote a forward rate, which is a rate specified today for the sale of currency on a future date, and the company and the bank can enter into a forward contract to exchange dollars for 200 million Korean won at the quoted rate on March 1.
Because a forward contract is a contract between two parties, those two parties can specify the amount that will be traded and the date the trade will occur. This contract is similar to your agreeing with a hotel that you will arrive on March 1 and rent a room for three nights at $200 per night. You are agreeing today to show up at the hotel on a future (specified) date and pay the quoted price when you arrive. The hotel agrees to provide you the room on March 1 and cannot change the price of the room when you arrive. With a forward contract, you are also agreeing that you will indeed make the purchase and you cannot change your mind; so, using the hotel room analogy, this would mean that the hotel will definitely charge your credit card for the agreed-upon $200 per night on March 1.
The forward contract is an individualized contract between the buyer and the seller; they are both under a contractual obligation to honor the contract. Because this contract is not standardized like the futures contract (so that it can be traded on an exchange), it can be tailored to the needs of the two parties. While the forward contract has the advantage of being fine-tuned to meet the company’s needs, it has a risk, known as counterparty risk, that the futures contract does not have. The forward contract is only as good as the promise of the counterparty. If the company enters into a forward contract to purchase 200 million Korean won on March 1 from its bank and the bank goes out of business before March 1, the company will not be able to make the exchange with a nonexistent bank. The exchanges on which futures contracts are traded guard the purchaser of a futures contract from this type of risk by guaranteeing the contract.

### Natural Hedges

A hedge simply refers to a reduction in the risk or exposure that a company has to volatility and uncertainty. We have been focusing on how a company might use financial market instruments to hedge, but sometimes a company can use a natural hedge to mitigate risk. A natural hedge occurs when a business can offset its risk simply through its own operations. With a natural hedge, when a risk occurs that would decrease the value of a company, an offsetting event occurs within the firm that increases the value of the company.
As an example, consider a British-based travel agency. One of the major tours the company offers is a tour of Italy. The company arranges for transportation, lodging, meals, and sightseeing for Brits to visit the highlights of Rome, Florence, and Venice. Because the company charges customers in British pounds but must pay the bus companies, hotels, and other service providers in Italy in euros, the travel agency faces significant transaction exposure. If the value of the British pound depreciates after the company sets the price it will charge for the tour but before it pays the Italian suppliers, the company will be harmed. In fact, if the British pound depreciates by a great deal, the company could end up in a situation in which the British pounds it collects are not enough to purchase the euros it needs to pay its suppliers.
The company could create a natural hedge by offering tours of London to individuals living in the European Union. The travel agency could charge people who live in Germany, Italy, Spain, or any other country that has the euro as its currency for a travel package to London. Then the agency would pay British restaurants, tour guides, hotels, and bus companies in British pounds. This segment of the business also has currency risk. If the British pound depreciates, the company gains because the euros it collects from its EU customers will purchase more British pounds than before.
Thus, the company has created a situation in which if the British pound depreciates, the decrease in value of its tours of Italy is exactly offset by the increase in value of its tours of London. If the British pound appreciates, the opposite occurs: the company experiences a gain in its division that charges British pounds for tourists traveling to Italy and an offsetting loss in its division that charges euros for tourists traveling to London.

### Options

A financial option gives the owner the right, but not the obligation, to purchase or sell an asset for a specified price at some future date. Options are considered derivative securities because the value of a derivative is derived from, or comes from, the value of another asset.

### Options Terminology

Specific terminology is used in the finance industry to describe the details of an options contract. If the owner of an option decides to purchase or sell the asset according to the terms of the options contract, the owner is said to be exercising the option. The price the option holder pays if purchasing the asset or receives if selling the asset is known as the strike price or exercise price. The price the owner of the option paid for the option is known as the premium.
An option contract will have an expiration date. The most common kinds of options are American options, which allow the holder to exercise the option at any time up to and including the expiration date. Holders of European options may exercise their options only on the expiration date. The labels American option and European option can be confusing as they have nothing to do with the location where the options are traded. Both American and European options are traded worldwide.
Option contracts are written for a variety of assets. The most common option contracts are options on shares of stock. Options are traded for US Treasury securities, currencies, gold, and oil. There are also options on agricultural products such as wheat, soybeans, cotton, and orange juice. Thus, options can be used by financial managers to hedge many types of risk, including currency risk, interest rate risk, and the risk that arises from fluctuations in the prices of raw materials.
Options are divided into two main categories, call options and put options. A call option gives the owner of the option the right, but not the obligation, to buy the underlying asset. A put option gives the owner the right, but not the obligation, to sell the underlying asset.

### Call Options

If a Korean company knows that it will need pay a $100,000 bill to a US supplier in six months, it knows how many US dollars it will need to pay the bill. As a Korean company, however, its bank account is denominated in Korean won. In six months, it will need to use its Korean won to purchase 100,000 US dollars.
The company can determine how many Korean won it would take to purchase $100,000 today. If the current exchange rate is , then it will need KWN 110,000,000 to pay the bill. The current exchange rate is known as the spot rate.
The company, however, does not need the US dollars for another six months. The company can purchase a call option, which is a contract that will allow it to purchase the needed US dollars in six months at a price stated in the contract. This allows the company to guarantee a price for dollars in six months, but it does not obligate the company to purchase the dollars at that price if it can find a better price when it needs the dollars in six months.
The price that is in the contract is called the strike price (exercise price). Suppose the company purchases a call contract for US dollars with a strike price of KWN 1,200/USD. While this contract would be for a set size, or a certain number of US dollars, we will talk about this transaction as if it were per one US dollar to highlight how options contracts work.
The company must pay a price, known as the premium, to purchase this call option contract. For our example, let’s assume the premium for the call option contract is KWN 50. In other words, the company has paid KWN 50 for the right to buy US dollars in six months for a price of KWN 1,200/USD.
In six months, the company makes a choice to either (1) pay the strike price of KWN 1,200/USD or (2) let the option expire. If the company chooses to pay the strike price and purchase the US dollars, it is exercising the option. How does the company choose which to do? It simply compares the strike price of KWN 1,200/USD to the market, or spot, exchange rate at the time the option is expiring.
If, six months from now, the spot exchange rate is , it will be cheaper for the company to buy the US dollars it needs at the spot price than it would be to buy the dollars with the option. In fact, if the spot rate is anything below , the company will not choose to exercise the option. If, however, the spot exchange rate in six months is , the company will exercise the option and purchase each US dollar for only KWN 1,200.
The profitability, or the payoff, to the owner of a call option is represented by the chart in  below. Possible spot prices are measured from left to right, and the financial gain or loss to the company of the option contract is measured vertically. If the spot price is anything less than KWN 1,200/USD, the option expires without being exercised. The company paid KWN 50 for something that ended up being worthless.
If, in six months, the spot exchange rate is , then the company will choose to exercise the option. The company will be saving KWN 25 for each dollar purchased, but the company originally paid 50 KWN for the contract. So, the company will be 25 KWN worse off than if it had never purchased the call option.
If the spot exchange rate is , the company will be in exactly the same position having purchased and exercised the call option as it would have been if it had not purchased the option. At any spot price higher than KWN 1,250/USD, the firm will be in a better financial position, or will have a positive payoff, because it purchased the call option. The more the Korean won depreciates over the next six months, the higher the payoff to the firm of owning the call contract. Purchasing the call contract is a way that the company can protect itself from the currency exposure it faces.
For any transaction, there must be two parties—a buyer and a seller. For the company to have purchased the call option, another party must have sold the call option. The seller of a call option is called the option writer. Let’s consider the potential benefits and risks to the writer of the call option.
When the company purchases the call option, it pays the premium to the writer. The writer of the option does not have a choice regarding whether the option will be exercised. The purchaser of the option has the right to make the choice; in essence, the writer of the option sold the right to make that decision to the purchasers of the call option.
 shows the payoff to the writer of the call option. Recall that the buyer of the call option will let the option expire if the spot rate is less than  when the call option matures in six months. If this occurs, the writer of the option collected the KWN 50 option premium when the contract was sold and then never hears from the purchaser again. This is what the writer of the option is hoping for; the writer of the call option profits when the options contract is not exercised
If the spot rate is above , then the holder of the option will choose to exercise the right to purchase the won at the option strike price. Then the writer of the option will be obligated to sell the Korean won at a price of KWN 1,200/USD. If the spot rate is , the option writer will be obligated to sell the dollars for KWN 50 less than what they are worth; because the option writer was initially paid a KWN 50 premium for taking on that obligation, the option writer will just break even. For any exchange rate higher than , the writer of the call option will have a loss.
The option contract is a zero-sum game. Any payoff the owner of the option receives is exactly equal to the loss the writer of the option has. Any loss the owner of the option has is exactly equal to the payoff the writer of the option receives.

### Put Options

While the call option you just considered gives the owner the right to buy an underlying asset, the put option gives the owner to right to sell an underlying asset. Take, for example, an Indian company that has a contract to provide graphic artwork for a US company. The US company will pay the Indian company 200,000 US dollars in three months.
While the Indian company receives US dollars, it must pay its workers in Indian rupees. Because the company does not know what the spot exchange rate will be in three months, it faces transaction risk and may be interested in hedging this exposure using a put option.
The company knows that the current spot rate is , meaning that the company would be able to use $200,000 to purchase  if it possessed the $200,000 today. If the Indian rupee appreciates relative to the US dollar over the next three months, however, the company will receive fewer rupees when it makes the exchange; perhaps the company will not be able to purchase enough rupees to cover the wages of its employees.
Assume the company can purchase a put option that gives it the right to sell US dollars in three months at a strike price of INR 75/USD; the premium for this put option is INR 5. By purchasing this put option, the company is spending INR 5 to guarantee that it can sell its US dollars for rupees in three months at a price of INR 75/USD.
If, in three months, when the company receives payment in US dollars, the spot exchange rate is higher than , the company will simply exchange the US dollars for rupees at that exchange rate, allowing the put option to expire without exercising it. The payoff to the company for the option is INR -5, the premium that was paid for the option that was never used (see ).
If, however, in three months, the spot exchange rate is anything less than , then the company will choose to exercise the option. If the spot rate is between  and , the payoff for the option is negative. For example, if the spot exchange rate is , the company will exercise the option and receive three more Indian rupees per dollar than it would in the spot market. However, the company had to spend INR 5 for the option, so the payoff is INR -2. At a spot exchange rate of , the company has a zero payoff; the benefit of exercising the option, INR 5, is exactly equal to the price of purchasing the option, the premium of INR 5.
If, in three months, the spot exchange rate is anything below , the payoff of the put option is positive. At the theoretical extreme, if the USD became worthless and would purchase no rupees in the spot market when the company received the dollars, the company could exercise its option and receive INR 75/USD, and its payoff would be INR 70.
Now that we have considered the payoff to a purchaser of a put contract, let’s consider the opposite side of the contract: the seller, or writer, of the put option. The writer of a put option is selling the right to sell dollars to the purchaser of the put option. The writer of the put option collects a premium for this. The writer of the put has no choice as to whether the put option will be exercised; the writer only has an obligation to honor the contract if the owner of the put option chooses to exercise it.
The owner of the option will choose to let the option expire if the spot exchange rate is anything above . If that is the case, the writer of the put option collects the INR 5 premium for writing the put, as shown by the horizontal line in . This is what the writer of the put is hoping will occur.
The owner of the option will choose to exercise the option if the exchange rate is less than . If the spot exchange rate is between  and , the writer of the put option has a positive payoff. Although the writer must now purchase US dollars for a price higher than what the dollars are worth, the INR 5 premium that the writer received when entering into the position is more than enough to offset that loss.
If the spot exchange rate drops below , however, the writer of the put option is losing more than INR 5 when the option is exercised, leaving the writer with a negative payoff. In the extreme, the writer of the put will have to purchase worthless US dollars for INR 75/USD, resulting in a loss of INR 70.
Notice that the payoff to the writer of the put is the negative of the payoff to the holder of the put at every spot price. The highest payoff occurs to the writer of the put when the option is never exercised. In that instance, the payoff to the writer is the premium that the holder of the put paid when purchasing the option (see ).
 provides a summary of the positions that the parties who enter into options contract are in. Remember that the buyer of an option is always the one purchasing the right to do something. The seller or writer of an option is selling the right to make a decision; the seller has the obligation to fulfill the contract should the buyer of the option choose to exercise the option. The most the seller of an option can ever profit is by the premium that was paid for the option; this occurs when the option is not exercised.

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Exchange rates are unpredictable. This leads to transaction risk, translation risk, and economic risk as currency values change. A forward contract is an agreement between two parties to make an exchange at a particular rate on a given date in the future. Companies can use options to mitigate the risks. A call option gives the holder the right, but not the obligation, to purchase an underlying asset. A put option give the holder the right, but not the obligation, to sell an underlying asset.

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### BMW in the United States

While the name BMW may sound German, a significant amount of BMW’s production occurs outside of Germany. Watch this video to learn about this international activity of BMW.


# Risk Management and the Financial Manager

## Interest Rate Risk

### Learning Outcomes

By the end of this section, you will be able to:
1. Describe interest rate risk.
2. Explain how a change in interest rates changes the value of cash flows.
3. Describe the use of an interest rate swap.
An interest rate is simply the price of borrowing money. Just as other prices are volatile, interest rates are also volatile. Just as volatility in other prices leads to uncertain cash flows for a company, volatility in interest rates can also lead to uncertain cash flows.

### Measuring Interest Rate Risk

Suppose that a company is supposed to pay a bill of $1,000 in 10 years. The present value of this bill depends on the level of interest rates. If the interest rate is 5%, the present value of the bill is . If the interest rate rises to 6%, the present value of the bill is . The increase in the interest rate by 1% causes the present value of the expected cash flow to fall by .
Interest rate risk can be highlighted by looking at bonds. Consider two $1,000 face value bonds with a 5% coupon rate, paid semiannually. One of the bonds matures in five years, and the other bond matures in 30 years. If the market interest rate is 5%, each of these bonds will sell for face value, or $1,000. If, instead, the market interest rate is 6%, the five-year bond will sell for $957.35 and the 30-year bond will sell for $861.62.
Notice that as the interest rate rises, the price of both of these bonds will fall. However, the price of the longer-term bond will fall by more than the price of the shorter-term bond. The longer-term bond price will fall by 1.38%; the shorter-term bond price will fall by only 0.43%.
Consider two additional $1,000 face value bonds. The difference is that these bonds have a 6% coupon rate, paid semiannually. If a bond has a 6% coupon rate and matures in five years, it will sell for $1,043.76 when the market interest rate is 5%. A 30-year bond that matures in 30 years and has a 6% coupon rate will sell for $1,154.54 when the market interest rate is 5%. However, if the interest rate in the economy is 6%, both of these bonds will sell for a price of $1,000. The price of the five-year bond will drop by 4.19%; the price of the 30-year bond will drop by 13.39%.
The sensitivity of bond prices to changes in the interest rate is known as interest rate risk. Duration is an important measure of interest rate risk that incorporates the maturity and coupon rate of a bond as well as the level of current market interest rates. Calculating duration is a complex topic that is beyond the scope of this introductory textbook, but it is useful to note that
1. the higher the duration of a bond, the more sensitive the price of the bond will be to interest rate changes;
2. the duration of a bond will be higher when market yields are lower, all else being equal;
3. the duration of a bond will be higher the longer the maturity of the bond, all else being equal; and
4. the duration of a bond will be higher the lower the coupon rate on the bond, all else being equal.

### Swap-Based Hedging

As the name suggests, a swap involves two parties agreeing to swap, or exchange, something. Generally, the two parties, known as counterparties, are swapping obligations to make specified payment streams.
To illustrate the basics of how an interest rate swap works, let’s consider two hypothetical companies, Alpha and Beta. Alpha is a strong, well-established company with a AAA (triple-A) bond rating. This means that Alpha has the highest rating a company can have. With this high rating, Alpha can borrow at relatively low interest rates. Often, companies in this situation will borrow at a floating rate. This means that their interest rate goes up and down as interest rates in the overall economy vary. The floating rate will be tied to a benchmark rate that is widely quoted in the financial press. Historically, companies have often used the London Interbank Offered Rate (LIBOR) as the benchmark rate. Because published quotes for LIBOR will be phased out by 2023, firms are beginning to use alternative rates. As of yet, no single alternative has emerged as the most commonly used rate; therefore, LIBOR will be used in our example. Suppose that Alpha finds that it can borrow money at rate equal to ; thus, if LIBOR is 2.75%, the company will pay 3.0% to borrow. If the company wants to borrow at a long-term fixed rate, its cost of borrowing will be 5.0%.
Beta has a BBB bond rating. Although this is considered a good, investment-grade rating, it is lower than the rating of Alpha. Because Beta is less creditworthy and a bit riskier than Alpha, it will have to pay a higher interest rate to borrow money. If Beta wants to borrow money at a floating rate, it will need to pay  If LIBOR is 2.75%, Beta must pay 3.5% on its floating rate debt. In order for Beta to borrow at a long-term fixed rate, its cost of borrowing will be 6.75%.
Let’s consider how these two companies can enter into a swap in which both parties benefit.  summarizes the situation and the rates at which Alpha and Beta can borrow. It also illustrates a way in which an interest rate swap can benefit both Alpha and Beta.
Alpha borrows in the capital markets at a fixed rate of 5%. Beta chooses to borrow at a floating rate that equals  Beta also agrees to pay Alpha a fixed rate of 5.5%. In essence, Beta is paying 5.5% to Alpha, 0.75% to its lender, and LIBOR to its lender.
In return, Alpha promises to pay Beta LIBOR. The exact amount that Alpha will pay to Beta fluctuates as LIBOR fluctuates. However, from Beta’s perspective, the payment of LIBOR it receives from Alpha exactly offsets the payment of LIBOR it makes to its lender. When LIBOR increases, the rate of  that Beta is paying to its lender increases, but the LIBOR rate it receives from Alpha also increases. When LIBOR decreases, Beta receives less from Alpha, but it also pays less to its lender. Because the LIBOR it receives from Alpha is exactly equal to the LIBOR it pays to its lender, Beta’s net amount of interest paid is 6.25%—the 5.5% it pays to Alpha plus the 0.75% it pays to its lender.
Alpha is in the position of paying 5.0% to its lender and LIBOR to Beta while receiving 5.5% from Beta. This means that Alpha’s net interest paid is  Alpha is said to have swapped its fixed interest rate for a floating rate. Because it is paying , it will experience fluctuating interest rates; however, as a company with a AAA bond rating, it is a strong, creditworthy company that can withstand that interest rate exposure. It would have cost Alpha  to borrow the money from its lenders at a variable rate. By participating in this swap arrangement, Alpha has been able to lower its interest rate by 0.75%.
Through this swap arrangement, Beta has been able to fix its interest rate at 6.25% rather than having a variable rate. This predictability is a benefit for a company, especially one that is in a bit more precarious position as far as its creditworthiness and stability. The 6.25% Beta pays as a result of this arrangement is 0.5% below the 6.75% it would have paid if it simply borrowed from its lenders at a fixed rate.

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When interest rates increase, the present value of future cash flows decreases. Duration is a measure of interest rate risk. A swap involves two parties agreeing to exchange something, often specified payment streams.

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### CFA Institute

This chapter supports some of the Learning Outcome Statements (LOS) in this CFA® Level I Study Session. Reference with permission of CFA Institute.


# The Americas, Europe, and Africa Before 1492

## Introduction

Globalization, the ever-increasing interconnectedness of the world, is not a new phenomenon, but it accelerated when western Europeans discovered the riches of the East. During the Crusades (1095–1291), Europeans developed an appetite for spices, silk, porcelain, sugar, and other luxury items from the East, for which they traded fur, timber, and Slavic people they captured and sold (hence the word slave). But when the Silk Road, the long overland trading route from China to the Mediterranean, became costlier and more dangerous to travel, Europeans searched for a more efficient and inexpensive trade route over water, initiating the development of what we now call the Atlantic World.
In pursuit of commerce in Asia, fifteenth-century traders unexpectedly encountered a “New World” populated by millions and home to sophisticated and numerous peoples. Mistakenly believing they had reached the East Indies, these early explorers called its inhabitants “Indians.” West Africa, a diverse and culturally rich area, soon entered the stage as other nations exploited its slave trade and brought its peoples to the New World in chains. Although Europeans would come to dominate the New World, they could not have done so without Africans and Native peoples ().


# The Americas, Europe, and Africa Before 1492

## The Americas

Most Native American origin stories assert that Native nations have always called the Americas home; however, some scholars believe that between nine and fifteen thousand years ago, a land bridge existed between Asia and North America that we now call Beringia. The first inhabitants of what would be named the Americas migrated across this bridge in search of food. When the glaciers melted, water engulfed Beringia, and the Bering Strait was formed. Later settlers came by boat across the narrow strait. (The fact that Asians and Native Americans share genetic markers on a Y chromosome lends credibility to this migration theory.) Continually moving southward, the settlers eventually populated both North and South America, creating unique cultures that ranged from the highly complex and urban Aztec civilization in what is now Mexico City to the woodland tribes of eastern North America. Recent research along the west coast of South America suggests that migrant populations may have traveled down this coast by water as well as by land.
Researchers believe that about ten thousand years ago, humans also began the domestication of plants and animals, adding agriculture as a means of sustenance to hunting and gathering techniques. With this agricultural revolution, and the more abundant and reliable food supplies it brought, populations grew and people were able to develop a more settled way of life, building permanent settlements. Nowhere in the Americas was this more obvious than in Mesoamerica ().

### THE FIRST AMERICANS: THE OLMEC

Mesoamerica is the geographic area stretching from north of Panama up to the desert of central Mexico. Although marked by great topographic, linguistic, and cultural diversity, this region cradled a number of civilizations with similar characteristics. Mesoamericans were polytheistic; their gods possessed both male and female traits and demanded blood sacrifices of enemies taken in battle or ritual bloodletting. Corn, or maize, domesticated by 5000 BCE, formed the basis of their diet. They developed a mathematical system, built huge edifices, and devised a calendar that accurately predicted eclipses and solstices and that priest-astronomers used to direct the planting and harvesting of crops. Most important for our knowledge of these peoples, they created the only known written language in the Western Hemisphere; researchers have made much progress in interpreting the inscriptions on their temples and pyramids. Though the area had no overarching political structure, trade over long distances helped diffuse culture. Weapons made of obsidian, jewelry crafted from jade, feathers woven into clothing and ornaments, and cacao beans that were whipped into a chocolate drink formed the basis of commerce. The mother of Mesoamerican cultures was the Olmec civilization.
Flourishing along the hot Gulf Coast of Mexico from about 1200 to about 400 BCE, the Olmec produced a number of major works of art, architecture, pottery, and sculpture. Most recognizable are their giant head sculptures () and the pyramid in La Venta. The Olmec built aqueducts to transport water into their cities and irrigate their fields. They grew maize, squash, beans, and tomatoes. They also bred small domesticated dogs which, along with fish, provided their protein. Although no one knows what happened to the Olmec after about 400 BCE, in part because the jungle reclaimed many of their cities, their culture was the base upon which the Maya and the Aztec built. It was the Olmec who worshipped a rain god, a maize god, and the feathered serpent so important in the future pantheons of the Aztecs (who called him Quetzalcoatl) and the Maya (to whom he was Kukulkan). The Olmec also developed a system of trade throughout Mesoamerica, giving rise to an elite class.

### THE MAYA

After the decline of the Olmec, a city rose in the fertile central highlands of Mesoamerica. One of the largest population centers in pre-Columbian America and home to more than 100,000 people at its height in about 500 CE, Teotihuacan was located about thirty miles northeast of modern Mexico City. The ethnicity of this settlement’s inhabitants is debated; some scholars believe it was a multiethnic city. Large-scale agriculture and the resultant abundance of food allowed time for people to develop special trades and skills other than farming. Builders constructed over twenty-two hundred apartment compounds for multiple families, as well as more than a hundred temples. Among these were the Pyramid of the Sun (which is two hundred feet high) and the Pyramid of the Moon (one hundred and fifty feet high). Near the Temple of the Feathered Serpent, graves have been uncovered that suggest humans were sacrificed for religious purposes. The city was also the center for trade, which extended to settlements on Mesoamerica’s Gulf Coast.
The Maya were one Mesoamerican culture that had strong ties to Teotihuacan. The Maya’s architectural and mathematical contributions were significant. Flourishing from roughly 2000 BCE to 900 CE in what is now Mexico, Belize, Honduras, and Guatemala, the Maya perfected the calendar and written language the Olmec had begun. They devised a written mathematical system to record crop yields and the size of the population, and to assist in trade. Surrounded by farms relying on primitive agriculture, they built the city-states of Copan, Tikal, and Chichen Itza along their major trade routes, as well as temples, statues of gods, pyramids, and astronomical observatories (). However, because of poor soil and a drought that lasted nearly two centuries, their civilization declined by about 900 CE and they abandoned their large population centers.
The Spanish found little organized resistance among the weakened Maya upon their arrival in the 1520s. However, they did find Mayan history, in the form of glyphs, or pictures representing words, recorded in folding books called codices (the singular is codex). In 1562, Bishop Diego de Landa, who feared the converted Native people had reverted to their traditional religious practices, collected and burned every codex he could find. Today only a few survive.

### THE AZTEC

When the Spaniard Hernán Cortés arrived on the coast of Mexico in the sixteenth century, at the site of present-day Veracruz, he soon heard of a great city ruled by an emperor named Moctezuma. This city was tremendously wealthy—filled with gold—and took in tribute from surrounding tribes. The riches and complexity Cortés found when he arrived at that city, known as Tenochtitlán, were far beyond anything he or his men had ever seen.
According to legend, a warlike people called the Aztec (also known as the Mexica) had left a city called Aztlán and traveled south to the site of present-day Mexico City. In 1325, they began construction of Tenochtitlán on an island in Lake Texcoco. By 1519, when Cortés arrived, this settlement contained upwards of 200,000 inhabitants and was certainly the largest city in the Western Hemisphere at that time and probably larger than any European city (). One of Cortés’s soldiers, Bernal Díaz del Castillo, recorded his impressions upon first seeing it: “When we saw so many cities and villages built in the water and other great towns on dry land we were amazed and said it was like the enchantments . . . on account of the great towers and cues and buildings rising from the water, and all built of masonry. And some of our soldiers even asked whether the things that we saw were not a dream? . . . I do not know how to describe it, seeing things as we did that had never been heard of or seen before, not even dreamed about.”
Unlike the dirty, fetid cities of Europe at the time, Tenochtitlán was well planned, clean, and orderly. The city had neighborhoods for specific occupations, a trash collection system, markets, two aqueducts bringing in fresh water, and public buildings and temples. Unlike the Spanish, Aztecs bathed daily, and wealthy homes might even contain a steam bath. A labor force of enslaved people from subjugated neighboring tribes had built the fabulous city and the three causeways that connected it to the mainland. To farm, the Aztec constructed barges made of reeds and filled them with fertile soil. Lake water constantly irrigated these , or “floating gardens,” which are still in use and can be seen today in Xochimilco, a district of Mexico City.
Each god in the Aztec pantheon represented and ruled an aspect of the natural world, such as the heavens, farming, rain, fertility, sacrifice, and combat. A ruling class of warrior nobles and priests performed ritual human sacrifice daily to sustain the sun on its long journey across the sky, to appease or feed the gods, and to stimulate agricultural production. The sacrificial ceremony included cutting open the chest of a criminal or captured warrior with an obsidian knife and removing the still-beating heart ().

### THE INCA

In South America, the most highly developed and complex society was that of the Inca, whose name means “lord” or “ruler” in the Andean language called Quechua. At its height in the fifteenth and sixteenth centuries, the Inca Empire, located on the Pacific coast and straddling the Andes Mountains, extended some twenty-five hundred miles. It stretched from modern-day Colombia in the north to Chile in the south and included cities built at an altitude of 14,000 feet above sea level. Its road system, kept free of debris and repaired by workers stationed at varying intervals, rivaled that of the Romans and efficiently connected the sprawling empire. The Inca, like all other pre-Columbian societies, did not use axle-mounted wheels for transportation. They built stepped roads to ascend and descend the steep slopes of the Andes; these would have been impractical for wheeled vehicles but worked well for pedestrians. These roads enabled the rapid movement of the highly trained Incan army. Also like the Romans, the Inca were effective administrators. Runners called  traversed the roads in a continuous relay system, ensuring quick communication over long distances. The Inca had no system of writing, however. They communicated and kept records using a system of colored strings and knots called the  ().
The Inca people worshipped their lord who, as a member of an elite ruling class, had absolute authority over every aspect of life. Much like feudal lords in Europe at the time, the ruling class lived off the labor of the peasants, collecting vast wealth that accompanied them as they went, mummified, into the next life. The Inca farmed corn, beans, squash, quinoa (a grain cultivated for its seeds), and the indigenous potato on terraced land they hacked from the steep mountains. Peasants received only one-third of their crops for themselves. The Inca ruler required a third, and a third was set aside in a kind of welfare system for those unable to work. Huge storehouses were filled with food for times of need. Each peasant also worked for the Inca ruler a number of days per month on public works projects, a requirement known as the . For example, peasants constructed rope bridges made of grass to span the mountains above fast-flowing icy rivers. In return, the lord provided laws, protection, and relief in times of famine.
The Inca worshipped the sun god Inti and called gold the “sweat” of the sun. Unlike the Maya and the Aztecs, they rarely practiced human sacrifice and usually offered the gods food, clothing, and coca leaves. In times of dire emergency, however, such as in the aftermath of earthquakes, volcanoes, or crop failure, they resorted to sacrificing prisoners. The ultimate sacrifice was children, who were specially selected and well fed. The Inca believed these children would immediately go to a much better afterlife.
In 1911, the American historian Hiram Bingham uncovered the lost Incan city of Machu Picchu (). Located about fifty miles northwest of Cusco, Peru, at an altitude of about 8,000 feet, the city had been built in 1450 and inexplicably abandoned roughly a hundred years later. Scholars believe the city was used for religious ceremonial purposes and housed the priesthood. The architectural beauty of this city is unrivaled. Using only the strength of human labor and no machines, the Inca constructed walls and buildings of polished stones, some weighing over fifty tons, that were fitted together perfectly without the use of mortar. In 1983, UNESCO designated the ruined city a World Heritage Site.

### NATIVE AMERICANS

With few exceptions, the North American Native cultures were much more widely dispersed than the Mayan, Aztec, and Incan societies, and did not have their population size or organized social structures. Although the cultivation of corn had made its way north, many Native people still practiced hunting and gathering. Horses, first introduced by the Spanish, allowed the Plains Natives to more easily follow and hunt the huge herds of bison. A few societies had evolved into relatively complex forms, but they were already in decline at the time of Christopher Columbus’s arrival.
In the southwestern part of today’s United States dwelled several groups we collectively call the Pueblo. The Spanish first gave them this name, which means “town” or “village,” because they lived in towns or villages of permanent stone-and-mud buildings with thatched roofs. Like present-day apartment houses, these buildings had multiple stories, each with multiple rooms. The three main groups of the Pueblo people were the Mogollon, Hohokam, and Anasazi.
The Mogollon thrived in the Mimbres Valley (New Mexico) from about 150 BCE to 1450 CE. They developed a distinctive artistic style for painting bowls with finely drawn geometric figures and wildlife, especially birds, in black on a white background. Beginning about 600 CE, the Hohokam built an extensive irrigation system of canals to irrigate the desert and grow fields of corn, beans, and squash. By 1300, their crop yields were supporting the most highly populated settlements in the southwest. The Hohokam decorated pottery with a red-on-buff design and made jewelry of turquoise. In the high desert of New Mexico, the Anasazi, whose name means “ancient enemy” or “ancient ones,” carved homes from steep cliffs accessed by ladders or ropes that could be pulled in at night or in case of enemy attack ().
Roads extending some 180 miles connected the Pueblos’ smaller urban centers to each other and to Chaco Canyon, which by 1050 CE had become the administrative, religious, and cultural center of their civilization. A century later, however, probably because of drought, the Pueblo peoples abandoned their cities. Their present-day descendants include the Hopi and Zuni tribes.
The Indigenous groups who lived in the present-day Ohio River Valley and achieved their cultural apex from the first century CE to 400 CE are collectively known as the Hopewell culture. Their settlements, unlike those of the southwest, were small hamlets. They lived in wattle-and-daub houses (made from woven lattice branches “daubed” with wet mud, clay, or sand and straw) and practiced agriculture, which they supplemented by hunting and fishing. Utilizing waterways, they developed trade routes stretching from Canada to Louisiana, where they exchanged goods with other tribes and negotiated in many different languages. From the coast they received shells; from Canada, copper; and from the Rocky Mountains, obsidian. With these materials they created necklaces, woven mats, and exquisite carvings. What remains of their culture today are huge burial mounds and earthworks. Many of the mounds that were opened by archaeologists contained artworks and other goods that indicate their society was socially stratified.
Perhaps the largest indigenous cultural and population center in North America was located along the Mississippi River near present-day St. Louis. At its height in about 1100 CE, this five-square-mile city, now called Cahokia, was home to more than ten thousand residents; tens of thousands more lived on farms surrounding the urban center. The city also contained one hundred and twenty earthen mounds or pyramids, each dominating a particular neighborhood and on each of which lived a leader who exercised authority over the surrounding area. The largest mound covered fifteen acres. Cahokia was the hub of political and trading activities along the Mississippi River. After 1300 CE, however, this civilization declined—possibly because the area became unable to support the large population.

### NATIVE PEOPLES OF THE EASTERN WOODLAND

Encouraged by the wealth found by the Spanish in the settled civilizations to the south, sixteenth- and seventeenth-century English, Dutch, and French explorers expected to discover the same in North America. What they found instead were small, disparate communities, many already ravaged by European diseases brought by the Spanish and transmitted among the Native peoples. Rather than gold and silver, there was an abundance of land, and the timber and fur that land could produce.
The Native peoples living east of the Mississippi did not construct the large and complex societies of those to the west. Because they lived in small autonomous clans or tribal units, each group adapted to the specific environment in which it lived (). These groups were by no means unified, and warfare among tribes was common as they sought to increase their hunting and fishing areas. Still, these tribes shared some common traits. A leader or group of tribal elders made decisions, and although the leader was a man, usually the women selected and counseled him. Gender roles were not as fixed as they were in the patriarchal societies of Europe, Mesoamerica, and South America.
Women typically cultivated corn, beans, and squash and harvested nuts and berries, while men hunted, fished, and provided protection. But both took responsibility for raising children, and most major Native societies in the east were matriarchal. In tribes such as the Iroquois, Lenape, Muscogee, and Cherokee, women had both power and influence. They counseled and passed on the traditions of the tribe. These complementary gender roles changed dramatically with the coming of the Europeans, who introduced, sometimes forcibly, their own customs and traditions to the natives.
Clashing beliefs about land ownership and use of the environment would be the greatest area of conflict with Europeans. Although tribes often claimed the right to certain hunting grounds—usually identified by some geographical landmark—Native peoples did not practice, or in general even have the concept of, private ownership of land. The European Christian worldview, on the other hand, viewed land as the source of wealth. According to the Christian Bible, God created humanity in his own image with the command to use and subdue the rest of creation, which included not only land, but also all animal life. Land, and the game that populated it, they believed, were there for the taking.

### Section Summary

Great civilizations had risen and fallen in the Americas before the arrival of the Europeans. In North America, the complex Pueblo societies including the Mogollon, Hohokam, and Anasazi as well as the city at Cahokia had peaked and were largely memories. The Eastern Woodland peoples were thriving, but they were soon overwhelmed as the number of English, French, and Dutch settlers increased.
Mesoamerica and South America had also witnessed the rise and fall of cultures. The once-mighty Mayan population centers were largely empty. In 1492, however, the Aztecs in Mexico City were at their peak. Subjugating surrounding tribes and requiring tribute of both humans for sacrifice and goods for consumption, the island city of Tenochtitlán was the hub of an ever-widening commercial center and the equal of any large European city until Cortés destroyed it. Further south in Peru, the Inca linked one of the largest empires in history through the use of roads and disciplined armies. Without the use of the wheel, they cut and fashioned stone to build Machu Picchu high in the Andes before abandoning the city for unknown reasons. Thus, depending on what part of the New World they explored, the Europeans encountered peoples that diverged widely in their cultures, traditions, and numbers.

### Review Questions


# The Americas, Europe, and Africa Before 1492

## Europe on the Brink of Change

The fall of the Roman Empire (476 CE) and the beginning of the European Renaissance in the late fourteenth century roughly bookend the period we call the Middle Ages. Without a dominant centralized power or overarching cultural hub, Europe experienced political and military discord during this time. Its inhabitants retreated into walled cities, fearing marauding pillagers including Vikings, Mongols, Arabs, and Magyars. In return for protection, they submitted to powerful lords and their armies of knights. In their brief, hard lives, few people traveled more than ten miles from the place they were born.
The Christian Church remained intact, however, and emerged from the period as a unified and powerful institution. Priests, tucked away in monasteries, kept knowledge alive by collecting and copying religious and secular manuscripts, often adding beautiful drawings or artwork. Social and economic devastation arrived in 1340s, however, when Genoese merchants returning from the Black Sea unwittingly brought with them a rat-borne and highly contagious disease, known as the bubonic plague. In a few short years, it had killed many millions, about one-third of Europe’s population. A different strain, spread by airborne germs, also killed many. Together these two are collectively called the Black Death (). Entire villages disappeared. A high birth rate, however, coupled with bountiful harvests, meant that the population grew during the next century. By 1450, a newly rejuvenated European society was on the brink of tremendous change.

### LIFE IN FEUDAL EUROPE

During the Middle Ages, most Europeans lived in small villages that consisted of a manorial house or castle for the lord, a church, and simple homes for the peasants or serfs, who made up about 60 percent of western Europe’s population. Hundreds of these castles and walled cities remain all over Europe ().
Europe’s feudal society was a mutually supportive system. The lords owned the land; knights gave military service to a lord and carried out his justice; serfs worked the land in return for the protection offered by the lord’s castle or the walls of his city, into which they fled in times of danger from invaders. Much land was communally farmed at first, but as lords became more powerful they extended their ownership and rented land to their subjects. Thus, although they were technically free, serfs were effectively bound to the land they worked, which supported them and their families as well as the lord and all who depended on him. The Catholic Church, the only church in Europe at the time, also owned vast tracts of land and became very wealthy by collecting not only tithes (taxes consisting of 10 percent of annual earnings) but also rents on its lands.
A serf’s life was difficult. Women often died in childbirth, and perhaps one-third of children died before the age of five. Without sanitation or medicine, many people perished from diseases we consider inconsequential today; few lived to be older than forty-five. Entire families, usually including grandparents, lived in one- or two-room hovels that were cold, dark, and dirty. A fire was kept lit and was always a danger to the thatched roofs, while its constant smoke affected the inhabitants’ health and eyesight. Most individuals owned no more than two sets of clothing, consisting of a woolen jacket or tunic and linen undergarments, and bathed only when the waters melted in spring.
In an agrarian society, the seasons dictate the rhythm of life. Everyone in Europe’s feudal society had a job to do and worked hard. The father was the unquestioned head of the family. Idleness meant hunger. When the land began to thaw in early spring, peasants started tilling the soil with primitive wooden plows and crude rakes and hoes. Then they planted crops of wheat, rye, barley, and oats, reaping small yields that barely sustained the population. Bad weather, crop disease, or insect infestation could cause an entire village to starve or force the survivors to move to another location.
Early summer saw the first harvesting of hay, which was stored until needed to feed the animals in winter. Men and boys sheared the sheep, now heavy with wool from the cold weather, while women and children washed the wool and spun it into yarn. The coming of fall meant crops needed to be harvested and prepared for winter. Livestock was butchered and the meat smoked or salted to preserve it. With the harvest in and the provisions stored, fall was also the time for celebrating and giving thanks to God. Winter brought the people indoors to weave yarn into fabric, sew clothing, thresh grain, and keep the fires going. Everyone celebrated the birth of Christ in conjunction with the winter solstice.

### THE CHURCH AND SOCIETY

After the fall of Rome, the Christian Church—united in dogma but unofficially divided into western and eastern branches—was the only organized institution in medieval Europe. In 1054, the eastern branch of Christianity, led by the Patriarch of Constantinople (a title that became roughly equivalent to the western Church’s pope), established its center in Constantinople and adopted the Greek language for its services. The western branch, under the pope, remained in Rome, becoming known as the Roman Catholic Church and continuing to use Latin. Following this split, known as the Great Schism, each branch of Christianity maintained a strict organizational hierarchy. The pope in Rome, for example, oversaw a huge bureaucracy led by cardinals, known as “princes of the church,” who were followed by archbishops, bishops, and then priests. During this period, the Roman Church became the most powerful international organization in western Europe.
Just as agrarian life depended on the seasons, village and family life revolved around the Church. The sacraments, or special ceremonies of the Church, marked every stage of life, from birth to maturation, marriage, and burial, and brought people into the church on a regular basis. As Christianity spread throughout Europe, it replaced pagan and animistic views, explaining supernatural events and forces of nature in its own terms. A benevolent God in heaven, creator of the universe and beyond the realm of nature and the known, controlled all events, warring against the force of darkness, known as the Devil or Satan, here on earth. Although ultimately defeated, Satan still had the power to trick humans and cause them to commit evil or sin.
All events had a spiritual connotation. Sickness, for example, might be a sign that a person had sinned, while crop failure could result from the villagers’ not saying their prayers. Penitents confessed their sins to the priest, who absolved them and assigned them penance to atone for their acts and save themselves from eternal damnation. Thus the parish priest held enormous power over the lives of his parishioners.
Ultimately, the pope decided all matters of theology, interpreting the will of God to the people, but he also had authority over temporal matters. Because the Church had the ability to excommunicate people, or send a soul to hell forever, even monarchs feared to challenge its power. It was also the seat of all knowledge. Latin, the language of the Church, served as a unifying factor for a continent of isolated regions, each with its own dialect; in the early Middle Ages, nations as we know them today did not yet exist. The mostly illiterate serfs were thus dependent on those literate priests to read and interpret the Bible, the word of God, for them.

### CHRISTIANITY ENCOUNTERS ISLAM

The year 622 brought a new challenge to Christendom. Near Mecca, Saudi Arabia, a prophet named Muhammad received a revelation that became a cornerstone of the Islamic faith. The Koran contained his message, affirming monotheism but identifying Christ not as God but as a prophet like Moses, Abraham, David, and Muhammad. Following Muhammad’s death in 632, Islam spread by both conversion and military conquest across the Middle East and Asia Minor to India and northern Africa, crossing the Straits of Gibraltar into Spain in the year 711 ().
The Islamic conquest of Europe continued until 732. Then, at the Battle of Tours (in modern France), Charles Martel, nicknamed the Hammer, led a Christian force in defeating the army of Abdul Rahman al-Ghafiqi. Muslims, however, retained control of much of Spain, where Córdoba, known for leather and wool production, became a major center of learning and trade. By the eleventh century, a major Christian holy war called the Reconquista, or reconquest, had begun to slowly push Muslims from Spain. With the start of the Crusades, the wars between Christians and Muslims for domination of the Holy Land (the Biblical region of Palestine), Christians in Spain and around Europe began to see the Reconquista as part of a larger religious struggle with Islam.

### JERUSALEM AND THE CRUSADES

The city of Jerusalem is a holy site for Jews, Christians, and Muslims. It was here King Solomon built the Temple in the tenth century BCE. It was here the Romans crucified Jesus in 33 CE, and from here, Christians maintain, he ascended into heaven, promising to return. From here, Muslims believe, Muhammad traveled to heaven in 621 to receive instructions about prayer. Thus claims on the area go deep, and emotions about it run high, among followers of all three faiths. Evidence exists that the three religions lived in harmony for centuries. In 1095, however, European Christians decided not only to retake the holy city from the Muslim rulers but also to conquer what they called the Holy Lands, an area that extended from modern-day Turkey in the north along the Mediterranean coast to the Sinai Peninsula and that was also held by Muslims. The Crusades had begun.
Religious zeal motivated the knights who participated in the four Crusades. Adventure, the chance to win land and a title, and the Church’s promise of wholesale forgiveness of sins also motivated many. The Crusaders, mostly French knights, retook Jerusalem in June 1099 amid horrific slaughter. A French writer who accompanied them recorded this eyewitness account: “On the top of Solomon’s Temple, to which they had climbed in fleeing, many were shot to death with arrows and cast down headlong from the roof. Within this Temple, about ten thousand were beheaded. If you had been there, your feet would have been stained up to the ankles with the blood of the slain. What more shall I tell? Not one of them was allowed to live. They did not spare the women and children.” A Muslim eyewitness also described how the conquerors stripped the temple of its wealth and looted private homes.
In 1187, under the legendary leader Saladin, Muslim forces took back the city. Reaction from Europe was swift as King Richard I of England, the Lionheart, joined others to mount yet another action. The battle for the Holy Lands did not conclude until the Crusaders lost their Mediterranean stronghold at Acre (in present-day Israel) in 1291 and the last of the Christians left the area a few years later.
The Crusades had lasting effects, both positive and negative. On the negative side, the wide-scale persecution of Jews began. Christians classed them with the infidel Muslims and labeled them “the killers of Christ.” In the coming centuries, kings either expelled Jews from their kingdoms or forced them to pay heavy tributes for the privilege of remaining. Muslim-Christian hatred also festered, and intolerance grew.
On the positive side, maritime trade between East and West expanded. As Crusaders experienced the feel of silk, the taste of spices, and the utility of porcelain, desire for these products created new markets for merchants. In particular, the Adriatic port city of Venice prospered enormously from trade with Islamic merchants. Merchants’ ships brought Europeans valuable goods, traveling between the port cities of western Europe and the East from the tenth century on, along routes collectively labeled the Silk Road. From the days of the early adventurer Marco Polo, Venetian sailors had traveled to ports on the Black Sea and established their own colonies along the Mediterranean Coast. However, transporting goods along the old Silk Road was costly, slow, and unprofitable. Muslim middlemen collected taxes as the goods changed hands. Robbers waited to ambush the treasure-laden caravans. A direct water route to the East, cutting out the land portion of the trip, had to be found. As well as seeking a water passage to the wealthy cities in the East, sailors wanted to find a route to the exotic and wealthy Spice Islands in modern-day Indonesia, whose location was kept secret by Muslim rulers. Longtime rivals of Venice, the merchants of Genoa and Florence also looked west.

### THE IBERIAN PENINSULA

Although Norse explorers such as Leif Ericson, the son of Eric the Red who first settled Greenland, had reached Canada roughly five hundred years prior to Christopher Columbus’s voyage, it was explorers sailing for Portugal and Spain who traversed the Atlantic throughout the fifteenth century and ushered in an unprecedented age of exploration and permanent contact with North America.
Located on the extreme western edge of Europe, Portugal, with its port city of Lisbon, soon became the center for merchants desiring to undercut the Venetians’ hold on trade. With a population of about one million and supported by its ruler Prince Henry, whom historians call “the Navigator,” this independent kingdom fostered exploration of and trade with western Africa. Skilled shipbuilders and navigators who took advantage of maps from all over Europe, Portuguese sailors used triangular sails and built lighter vessels called caravels that could sail down the African coast.
Just to the east of Portugal, King Ferdinand of Aragon married Queen Isabella of Castile in 1469, uniting two of the most powerful independent kingdoms on the Iberian peninsula and laying the foundation for the modern nation of Spain. Isabella, motivated by strong religious zeal, was instrumental in beginning the Inquisition in 1480, a brutal campaign to root out Jews and Muslims who had seemingly converted to Christianity but secretly continued to practice their faith, as well as other heretics. This powerful couple ruled for the next twenty-five years, centralizing authority and funding exploration and trade with the East. One of their daughters, Catherine of Aragon, became the first wife of King Henry VIII of England.
The year 1492 witnessed some of the most significant events of Ferdinand and Isabella’s reign. The couple oversaw the final expulsion of North African Muslims (Moors) from the Kingdom of Granada, bringing the nearly eight-hundred-year Reconquista to an end. In this same year, they also ordered all unconverted Jews to leave Spain.
Also in 1492, after six years of lobbying, a Genoese sailor named Christopher Columbus persuaded the monarchs to fund his expedition to the Far East. Columbus had already pitched his plan to the rulers of Genoa and Venice without success, so the Spanish monarchy was his last hope. Christian zeal was the prime motivating factor for Isabella, as she imagined her faith spreading to the East. Ferdinand, the more practical of the two, hoped to acquire wealth from trade.
Most educated individuals at the time knew the earth was round, so Columbus’s plan to reach the East by sailing west was plausible. Though the calculations of Earth’s circumference made by the Greek geographer Eratosthenes in the second century BCE were known (and, as we now know, nearly accurate), most scholars did not believe they were dependable. Thus Columbus would have no way of knowing when he had traveled far enough around the Earth to reach his goal—and in fact, Columbus greatly underestimated the Earth’s circumference.
In August 1492, Columbus set sail with his three small caravels (). After a voyage of about three thousand miles lasting six weeks, he landed on an island in the Bahamas named Guanahani by the native Lucayans. He promptly christened it San Salvador, the name it bears today.

### Section Summary

One effect of the Crusades was that a larger portion of western Europe became familiar with the goods of the East. A lively trade subsequently developed along a variety of routes known collectively as the Silk Road to supply the demand for these products. Brigands and greedy middlemen made the trip along this route expensive and dangerous. By 1492, Europe—recovered from the Black Death and in search of new products and new wealth—was anxious to improve trade and communications with the rest of the world. Venice and Genoa led the way in trading with the East. The lure of profit pushed explorers to seek new trade routes to the Spice Islands and eliminate Muslim middlemen.
Portugal, under the leadership of Prince Henry the Navigator, attempted to send ships around the continent of Africa. Ferdinand of Aragon and Isabella of Castile hired Columbus to find a route to the East by going west. As strong supporters of the Catholic Church, they sought to bring Christianity to the East and any newly found lands, as well as hoping to find sources of wealth.

### Review Questions