International Finance

Front 1

Describe the current state and future direction of exchange rate arrangements. Explain the fundamental factors that are likely to pursuade the choice of an exchange rate arrangement.

Back 1

Eight regimes.
Dollar, Euro, Yen and Pound fluctuate against each other.
Most others are pegged to a single currency (dollar, euro) or basket of currencies.

Flexible Rates:
Easier external adjustments
National policy autonomy
Allows balance-of-payments to equilize without policy interference.
Policies can be used to meet other economic goals.
However, exchange rate uncertainty can hampter international trade and investment. This can be mitigated through hedging exchange risk through currency forward or options contracts.

It is a trade-off between national policy independence and international economic integration.

Fixed rates:
Policy tools must be committed to maintaining the exchange rate so they lose policy autonomy.
Eliminates exchange rate uncertainty and promotes international trade.

Front 2

Assume that foreign government interest rates expected to rise above comparable US government interest rates. What does this suggest about the future strenght or weakness of the US dollar?

Back 2

Interest Rate Parity = exchange rate depends on relative interest rates between two countries.

According to IRP, other things being equal, a lower US interest rate will lead to depreciation in the dollar (less people will want to invest because they can get more $$ elsewhere).

Front 3

Suppose that you are in a meeting and an Analyst proposes the following exchange rate model of the Australian Dollar.

S = 1.3 (M*-M) + 0.5(Y*-Y) + 0.8(r-r*)

Where
S = the % change int he spot exchange rate (in A$/$)
M - the money supply
Y = real GDP
r = a short-term real interest rate.

A. Suppose that the Australian central bank reduced the money supply by 5%, which results in a rise in short-term interest rates from 10% to 10.5% and brings down inflation rate without slowing economic growth. Also, assume that the US variables all stay constant. using the model, what will happen to the A$/$ exchange rate?

Back 3

A. Change in S = 1.3(-5%) + 0.5(0) + 0.8 (10.5% - 10%) = -0.065 + 0 + 0.004 =
-0.061 or -6.1% change in the A$/$ spot rate.

Front 4

Suppose that you are in a meeting and an Analyst proposes the following exchange rate model of the Australian Dollar.

S = 1.3 (M*-M) + 0.5(Y*-Y) + 0.8(r-r*)

Where
S = the % change int he spot exchange rate (in A$/$)
M - the money supply
Y = real GDP
r = a short-term real interest rate.

B. Given your growing international finance expertise, describe which additional variables the Analyst should likely include in this model and why they should be included.

Back 4

Velocity of money (fundamental variable) - sometimes referred to as multiplier effect. It tracks how many times a single dollar is spent in a given time frame. Change in VOM is a predictor of future GDP changes and consequently a predictor of exchange rate changes.

Long-term moving average (techical variable) - takes into account the history of the economy and fundamental goals of the country. Good predictor of long-term exchange rate pricing.

Short-term moving average (technical variable) - looks at historical figures, but gives greater weight to recent changes in the exchange rate. Most useful in the short-run but ultimately the exchange rate should move toward the long-term average.

Front 5

Describe why an understanding of currency levels and movements is important.

Back 5

Since the advent of the flexible exchange system exchange rates have been more volatile and erratic.

The scope of business activities has become highly international.

Many business decisions are now based on forecasts of future exchange rates and the quality of these decisions is dependent upon accuracy of exchange rate forecasts.

Exchange rates impact MNC sourcing, production, financing and marketing strategies.

Companies cannot measure their exchange rate exposure without an understanding of currency movements.

Movement of currency values can have a direct affect on a company's value and assets.

Front 6

An article from the International Herald Tribune discusses homemaker foreign exchange (FX) trading in Japan. Discuss important FX factors that these homemakers should consider in their FX investment decisions.

Back 6

Non-arbitrage condition of IRP, which must hold if financial markets are in equilibrium. When IRP is not holding, there may be profitable opporunity for trading. (IRP does not hold due to trasaction and capital costs)

The differences in the bid-ask spread means they may find the money they're trading becomes nonpositive. If so, the profit turns negative and can be attributed to transaction costs.

Capital controls can cause deviations from IRP. Governments sometimes restrict capital flows (inbound and outbound) through jawboning, imposing taxes or outright bans on cross-border capital movements. This can impair arbitrage process.

NOTE: Japan imposed capital controls on and off until 1980 when they took a more liberal stance on FX transactions with the Foreign Exchange and Foreign Trade Control Law. Once this law went into effect the deviations from IPR tended to hover around zero, indicating that the controls were not contributing to profit opportunities, but rather acting as barriers to FX trading.

Front 7

What are the three factors that cause a bond's price to change? What is the predicted direction of change for the bond's price from changes in these factors?

Back 7

Changes in interest rates: As interest rates rise, the price of the bond will go down.

Changes in expected cash flows: If cash flows go down, the price of the bond will go down. This can occur from default or expected default.

Changes in maturity: A premium bond will converge downwards toward face value whiel a discount bond will rise toward face value.

Front 8

From a US investor's perspective, how do the risks associated with non-dollar denominated bonds impact the price of the bond and the dollar denominated return?

Back 8

The risk is the change in exchange rates over the life of the bond. If the dollar appreciates, the repayment will be worth more than a return of principal in the non-dollar denomination. Therefore, the bond includes a forward contract.

If the non-dollar denomination is likely to depreciate, then this would be worth the investment for the US investor. This also means the price of the bond could be slightly higher.

Front 9

Describe the alternative international equity investment instruments that are available to individual investors.

Back 9

International bond investment
International mutual funds
Country funds
Internally cross-linked stocks
American Depository Receipts
World Equity Benchmark Shares
Hedge Funds

Front 10

Describe the benefits of international portfolio diversification and why they are likely to be greater or less in the next decade than in the last decade.

Back 10

Due to economic, political, institutional, and psychological factors security returns are much less correlated across countries than within a country. Business cycles are also often asynchronous among countries which further decreases security correlation. Investing internationally makes it possible to diversify away more risk.

The benefits to international diversification will increase in the next decade for the same reasons it increased in the previous. Increased deregulation of world financial markets and the introduction of new investment vehicles which off the benefits of international diversification without excessive costs and exchange rate risk.

Front 11

In Berkshire Hathaway's annual report to investors a few years ago, Warren Buffet discussed his investment positions. Please see the PDF file that contains the relevant section of the report. Discuss why you agree or disagree with his currency investment perspectives and positions.

Back 11

Agree because:
Dollar is overpriced and will depreciate
The level 3 junk bonds are less risky than their returns suggest, hence they put their money in currency exchange and junk bonds for US firms that are traded abroad.

Front 12

An article from the Wall Street Journal discusses China's call for the creation of a new currency to eventually replace the US dollar as the world's standard. Discuss your perspectives on this issue.

Back 12

It will be difficult because central banks of the world hold a major portion of their external reserves in dollars, which means they will have to sell off their reserves to buy the new currency.

It would take away the special priveledges the US enjoys, such as running trade deficits without having to hold much foreign exchange reserves.

The US will not be able to conduct international transactions without bearing exchange risks.

Value of the dollar will plunge in the exchange market as its demand by foreign invetors will collapse.

Would affect firms that have hedged their foreign exchang risks.

Third world countries will benefit from the change as the value of debt owed will decrease.

Nations that rely on US exports, with large dollar reserves, or use dollars as their official currency will be greatly affected.

Nations with stable common currencies such as the EU zones, and Switzerland will benefit from the change.

Front 13

A recent article discusses the changing face of private equity including the fact that private equity funds are increasingly looking outside the US for opportunities. Based on your country analysis project, why would you recommend that a private equity firm invest or not invest in your selected country?

Back 13

Private equity firms have already sought investment opportunities in UAE.

Traditionally, Middle East investors look to buy US assets (vice the other way around).

There is a potential opportunity for investment in Dubai.

They must consider the recent economic downturn in UAE. NASDAQ Dubai is still struggling to gain new listings and the property boom has hit the region hard financially.

There is some concern that deals already struck are going to have a lower than expected return due to the economic slump.

Though new listings are down on NASDAQ Dubai, in the first quarter 2009 there was a 63% increas ein volument which could mean opportunities for investment are just around the corner.

Front 14

Discuss why firms often partake in foreign direct investment.

Back 14

Firms partake in FDI due to market imperfections; imperfections in product, factor, and capital markets.
• Trade Barriers – imperfect markets created by governments. Governments impose tariffs, quotas and other restrictions on exports and imports of goods and services. Facing these issues, the firm may decide to simply move production to foreign countries as a means of circumventing trade barriers.
• Imperfect Labor Market – labor services may be underpriced in certain countries (Mexico, India). There are persistent wage differentials among countries.
• Intangible Assets – technological, managerial, marketing know-how, superior R&D capabilities and brand names that are hard to package and sell to foreigners. The property rights of these intangible assets are hard to establish and protect (the formula for Coca-Cola) particularly in foreign countries where legal recourse is not readily available.
• Vertical Integration - MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable price. And if they gain monopolistic control of the input market they can serve as a barrier to entry into the industry. This is very common with natural resources (owning oil fields, forests, etc.).
• Product Life Cycle – FDI takes place when the product reaches maturity and cost becomes an important consideration. Early in a product life-cycle demand overseas is not normally very high. Then, as the product develops, it is exported to other countries. As demand grows the company may choose to start production in the country demanding the product to serve the local market. Then, as demand increases even more keeping costs down becomes more important to stay competitive. Cost considerations might then induce the US firm to partake in FDI in a low-cost country and export back to the US.
• Shareholder Diversification Services – if shareholders cannot diversity their portfolio holdings because of barriers to cross-border capital flows, firms can provide their shareholders with indirect diversification through FDI. Shareholders indirectly benefit from diversification, even if they are not directly holding foreign shares. Capital market imperfections motivate firms to undertake FDI.

Front 15

Define foreign exchange and foreign political risk exposure for a firm. Discuss whether or not a domestic firm is subject to foreign exchange and foreign political risk.

Back 15

Foreign Exchange Risk: The risk of facing uncertain future exchange rates. The risk of an investment value changing due to changes in currency exchange rates. Measured by the sensitivities of the future home currency values of the firm’s assets and liabilities and the firm’s operating cash flows to random changes in exchange rates.

Political Risk: Potential losses to the parent firm resulting from adverse political developments in the host country. Ranges from unexpected changes in tax rules to outright expropriation of assets held by foreigners. Countries can change the “rules of the game” at their will. Companies must be particularly careful when operating in a country without a tradition of the rule of law.

Macro risk: where all foreign operations are affected by adverse political developments in the host country.

Micro risk: where only selected areas of foreign business operations or particular foreign firms are affected.

Transfer risk: arises from uncertainty about cross-border flows of capital, payments, know-how and the like.

Operational risk: which is associated with uncertainty about the host country’s policies affecting the local operations of MNCs.

Control risk: which arises from uncertainty about the host country’s policy regarding ownership and control of local operations.

Domestic firms are subject to both foreign exchange and foreign political risks.
• The marketplace is now a global marketplace, even if you are a domestic firm.
• As the economy becomes increasingly globalized, more firms are subject to international competition.
• If your competitors cost of goods decreases because of a change in exchange rates, it impacts the domestic firm’s competitiveness and potentially market share. Additionally, competitors costs can increase or decrease based on government decisions (political risk).
• The dollar value of a domestic firm’s assets and liabilities can be impacted by exchange rates. If the firm borrows in a foreign currency, the value of those assets is dependent upon the exchange rate.
• If a domestic firm obtains parts, goods or services from any multinational companies the prices of those parts, goods and services can be impacted when exchange rates fluctuate. Additionally, political risk is an issue in this scenario as governments may impose new taxes or quotas on exports.
• A domestic firm’s stock returns can be influenced by the dollar’s value.

Front 16

What are the key differences among economic exposure, transaction exposure and translation exposure?

Back 16

Transaction Exposure (CH 8) is exchange rate risk applied to the firm’s home currency cash flows. Usually occurs when firm is faced with contractual cash flows that are fixed in foreign currencies. (short-term econ exposure)
o Can use financial hedge to eliminate this exposure.
 Forward Hedge – lock in future exchange rate today
 Money Market Hedge – Invest today at discount rate in foreign currency so you net what you owe at maturity
 Options Market Hedge – buy calls to hedge a payable and puts to hedge receivable
 Cross-Hedging – take a position in a correlated asset

Economic Exposure (CH 9) is exchange rate risk applied to a firm’s competitive position (similar to transaction exposure, but longer term)
o Looking for impact of unanticipated changes in the exchange rate
o Firms that operate purely domestically can still have foreign exchange exposure (for example, competitors may operate internationally and may gain competitive advantage)
o Defined as the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to unanticipated changes in exchange rates
 Can separate this into the effect on assets and liabilities (asset exposure) and the effect on operating cash flows (operating exposure) for statistical measurement purposes
• Regression formula can be used to quantify asset exposure
• Operating exposure is harder to quantify

Translation Exposure (CH10) is exchange rate risk applied to a firm’s consolidated financial statements (accounting exposure)
o How do unanticipated exchange rate changes effect the financial statements
o 4 translation methods
 Current/Noncurrent Method
• Assets and liabilities translated based on their maturity
o Current assets translated at spot rate
o Noncurrent assets translated at historical rate in effect when item was first recorded
 Monetary/Nonmonetary Method
• All monetary balance sheet accounts (cash, securities, AR) of a foreign subsidiary translated at the current exchange rate
• All non-monetary balance sheet accounts (owner’s equity, land) are translated at the historical rate in effect when items were first recorded
 Temporal Method
• Assets and Liabilities should be translated based on how they are carried on the books
o Balance sheet accounts carried at their current value use the current exchange rate
o Accounts carried as historical costs use historical rates in effect when items were added to the books
 Current Rate Method
• All balance sheet items (except stockholder’s equity) are translated at the current exchange rate
o Gains and losses do not go through income statement with this method, so cumulative translation adjustment (CTA) is needed on balance sheet

Front 17

Should a firm hedge? Why or why not?

Back 17

Why should a firm NOT Hedge:
• Exchange exposure management at the corporate level is redundant when stockholders can manage the exposure themselves
• What matters in firm valuation is only systematic risk; corporate risk management may only reduce the total risk. Thus, corporate exposure management does not necessarily add to the value of the firm.
Why should a firm Hedge:
• Reduces speculation and uncertainty
• Various market imperfections make a case for hedging:
o Information asymmetry
o Differential transaction costs
o Default costs
o Progressive corporate taxes
• Corporate risk management is relevant to maximize firm’s value. To the extent that for various reasons, stockholders themselves cannot properly manage exchange risk, the firm’s managers can do it for them, contributing to the firm’s value.
• Studies show that corporate hedging contributes to firm value.

Front 18

GM exports cars to Spain, but a strengthening, but the strenghtening of the dollar against the Euro would hurt sales of GM cars in Spain. In the Spanish market, GM faces competition from Italian and French car makers whose operating currencies are the Euro. What kind of measures would you recommend so that GM can maintain its market share in Spain?

Back 18

General Motors should consider the following strategies for managing the operating exposure they’re experiencing in Spain:
• Selecting low-cost production sites—Use low-cost production facilities to mitigate the unfavorable effect of the exchange rate
• Flexible sourcing policy—could consider sourcing automotive parts in countries that use the Euro and thus reduce the exposure of the dollar-Euro exchange in Spain
• Diversification of the market—Consider selling autos in countries where there is an expected depreciation of the dollar against the local currency to counteract the effect in Spain.
• Product differentiation and R&D efforts—Possibility to introduce new products to the market that may sell better than the autos and counteract the effects of the exchange.
• Financial hedging—lend or borrow in the Euro

Front 19

Discuss the extend to whcih financial innovation is useful, desirable or necessary.

Back 19

The extent to which financial innovation is useful and necessary is:
• Reducing access barriers
• Speeding up velocity of narrow money and reduction of use of physical cash(i.e. use of credit cards, E-money, online payments as means of payments)
• Transacting business globally through electronic means
• Useful for lowering cost of capital
• Necessary for improvement of financial intermediaries
Financial innovation becomes harmful when invented financial products innovated are mismanaged (e.g. current mortgage crisis which was caused by harmful interest rate programs, Inflated home prices, Adjustable credit card interest rates, inventing lending programs for less qualified candidates)