Finance Internationale

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Finance Internationale

• Pr. Ariane Chapelle
• Année académique 2004 - 2005

Contact E-mail ariane.chapelle_at_ulb.ac.be Site
web www.solvay.edu/cours/chapelle
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Contents

• Part 1 Fundamentals of International Finance
• 1.1.Introduction the financial environment
• Types of currencies
• Impossible Trinity
• 1.2. Exchange rate determination family of
  models
• 1. Parity Conditions
• 2. Balance of Payments approach
• 3. Assets Approach
• 4. Currency Forecasting
• 1.3. The Economics of Monetary Union
• The case for a greater fixity in exchange rates
• Optimal single currency zone criteria
• Monetary integration in the European Union

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Contents

• Part 2 International Corporate Finance
• 2.1. Foreign Exchange Exposure
• Transaction exposure
• Operating exposure
• 2.2. Financing the Global Firm
• Sourcing equity globally
• Financial structure and international debt
• 2.3. Foreign Investment Decision
• FDI theory and strategy
• Multinational capital budgeting
• Adjusting for risk
• 2.4. Managing Multinational Operations
• Repositioning funds
• Working capital management

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References

• Fundamentals
• Shapiro, A., Foundation of Multinational
  Financial Management, Whiley ed., 2003, available
  on http//knowledgespace.solvay.edu
• See my bookshelve - Bookmarks on the Shapiro 2003
• European Union
• De Grauwe, P., The Economics of Monetary Union,
  Oxford University Press ed., 2003.
• Part 2
• Eiteman, D., Stonehill, A. and Moffet, M.,
  Gestion et finance internationale, Pearson Ed.,
  10e ed., 2004.

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Requirements

• Prérequisites
• Good knowledge of Corporate Finance basics
• Some knowledge of Macroeconomics and Monetary
  Economics
• Assignments (40 of final grade)
• Every 2 weeks 1-2 pages assignment to hand in
  for the following week, based on internet
  exercices from textbooks
• Syndicates of max. 2 students
• Part 2
• Eiteman, D., Stonehill, A. and Moffet, M.,
  Gestion et finance internationale, Pearson Ed.,
  10e ed., 2004.

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The international financial system

• Introduction
• Different forms of exchange rates organisation
• fixed
• floating
• managed
• monetary unions
• Questions of
• adjustment of balance of paiements
• liquidity provision in the system
• international money definition and usage

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The international financial system

• Impossible Trinity 
• Exchange rate stability
• Full financial integration (free capital flows)
• Monetary independence
• Is there a best system?
• What design of institutions?

Full Capital Controls
Impossible Trinity
Monetary Independence
Exchange rate stability
Pure float
Monetary Union
Full Financial Integration
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The international financial system

• International money
• Characteristics International money should be
• defined
• convertible
• inspire confidence
• store of value
• Summary issues concerns of financial markets
• Adjustments of BOP
• Provision of liquidity
• 4 different systems address these 2 issues.

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The international financial system

• Four types of International Financial systems
• Automatic mechanisms (of adjustments)
• Pure floating rates between the two World Wars
• Pure fixed exchange rates gold period
• (N-1) Systems
• N countries linked to gold a large country, its
  currency international money
• N-1 countries linked to N fixed exchange rate
  regime Bretton Woods
• Policy coordination Multilateral mechanisms
  SME
• Monetary union EU

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Automatic Mechanisms

• Two mechanisms can be defined as fully automatic
  
• Freely floating exchange rate system
• Fully fixed commodity standard
• Freely floating no BOP problem any
  disequilibrium leads to automatic adjustment of
  exchange rates.
• Automatic market mechanism of the demand / supply
  market for foreign exchange.
• Liquidity in the system is unnecessary, provided
  that adjustment occurs immediatly
• International money is not explicitly specified
  a few currencies will be widely used as
  international means of payment.

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Automatic Mechanisms

• Fully fixed commodity standards
• Fiduciary money is backed by a particular
  commodity (ex. Gold)
• The ratio of fiduciary money to the reserves of
  the commodity is fixed, and the monetary
  authorities garantee free convertibility.
• All countries set a fixed price between their
  national currency and the commodity
• All currencies are tied together -gt exchange
  rates are fixed.
• The international money is the commodity.
• BOP disequilibira are eliminated by transfering
  the commodity from the deficit country to the
  surplus country, leading to
• a contraction of the money supply in deficit
  country
• an expansion of the money supply in the surplus
  country
• leading to symmetrical adjustments

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The international financial system

• In theory imbalance of BOP does not depend of
  FX rate
• In practice
• prices and wages are sticky (no downward
  flexibility of prices)
• some regional shocks can create asymmetric
  disequilibrium
• large players like government and financial
  institutions influence equilibrium
• Problem of adjustments central concern of
  government
• Need for design of institutions

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Exchange rate determination
Parity Conditions 1. Inflation rate
differential 2. Interest rate differential 3.
Forward exchange rate 4. Interest rate parity
Spot Exchange Rate
Assets Models 1. Interest rate differential 2.
Economic Growth prespectives 3. Demand and Supply
of Assets 4. Economic Stability 5. Speculation
and market liquidity 6. Political risk
Balance of Paiements Approach 1. Current
account 2. Direct portfolio investment flows 3.
Exchange rate regimes 4. Level of currency
reserves
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Exchange rate determination

• Approaches for exchange rate determination
• 1. Parity Conditions
• Purchasing Power Parity
• Interest Rate Parity
• Fisher Effect
• Forward market
• 2. Balance of payments approaches
• FX such that BOP in equilibrium
• Adjustment mechanisms
• 3. Asset Models
• Foreign direct investment
• Country risk
• Alternative opportunities
• Growth prospects
• Others news, bubbles, overshooting...

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1. Parity Conditions

• Five key theoretical economic relationships
  results from arbitrage activities.
• Arbitrage regards exchange rates, interest rates,
  inflation rates, and the link between domestic
  and international financial markets
• Purchasing Power Parity (PPP)
• Fisher Effect (FE)
• International Fisher Effect (IFE)
• Interest Rate Parity (IRP)
• Forward rates as unbiased predictors of future
  spot rates (UFR)

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1. Parity Conditions

• Relationships among Spot Rates, Forward Rates,
  Inflation Rates, and Interest Rates (Shapiro, p
  118)

Expected percentage change of spot rate of
foreign currency - 3
IFE
UFR
PPP
Interest rate differential 3
Forward discount or premium on foreign currency -
3
IRP
FE
Expected inflation rate differential 3
Common denominator of these parity conditions
adjustment of the various rates and prices to
inflation (csq of a money supply in excess of
real output growth - monetary theory)
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1.1. Purchasing Power Parity

• Parity Relations - PPP
• Absolute Purchasing Power Parity - Definition
• P S.P law of one price
• Domestic Prices (P) Exchange Rate (S).Foreign
  Prices (P)
• P and P general price indices
• Rearranging S P/P
• The spot exchange rate between 2 currencies is
  equal to the ratio of general price levels
  between the 2 countries.
• Originally from Swedish Economist Gustav Cassel
  in 1918.

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1.1. Purchasing Power Parity - absolute

• Absolute Purchasing Power Parity - Hypotheses
• Hypotheses
• No transports costs
• Perfect information (on prices in both countries)
• Homogeneous goods
• No trade barriers
• -gt Equality brought by arbitrage
• Definition of arbitrage buy and resell without
  risk but with a profit
• Example of arbitrage buy 20 kg of gold in
  Belgium at 50.000 euros, and resell is
  immediately in France at 53.000 euros. Question
  is this imaginable for any goods?

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PPP Illustration Big Mac Index Jan 2004 Dec 2004
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1.1. Purchasing Power Parity - Relative

• Relative Purchasing Power Parity - Definition
• S b.P/P
• Prices across countries might differ by a
  constant factor b, accounting for transport
  costs and information costs.
• Focuses on the movements in the exchange rate and
  the extent to which they reflect differential
  inflation.
• Approximated by dS/S dP/P - dP/P the
  exchange rate will adjust to reflect changes in
  the price levels of the two countries.
• Relative PPP says that currencies with high rates
  of inflation should devalue relative to
  currencies with lower rates of inflation.

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1.1. PPP absolute relative

• Interpretation
• No precision of causality does the prices
  determine the FX rate, or the reverse?
• Goods included traded non traded? If yes,
  hypothesis of perfect substitutability and
  similar productivity levels.
• If only traded goods included PPP close to a
  tautology
• Short-run or long-run anchor?
• -gt alternative cost parity theory
• (more seducing, but same nature of problems)

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1.1. PPP absolute relative

• Theoretial criticisms (6)
• Information costs, transport costs, trade
  barriers exist, and could change over time.
• The direction of causality is unclear -gt exchange
  rates could determine prices.
• All disturbances are monetary, or more important
  than real ones
• -gt no account of productivity changes in one
  country.
• No account of productivity differential between
  traded non-traded goods sectors.
• Ignores the role of income in determining
  exchange rates, and its consequences on a change
  in demand.
• No role of capital flows. Sole focus on exchange
  of goods.

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1.1. PPP in practice

• Real exchange rate nominal exchange rate
  adjusted for changes in the relative purchasing
  power of each currency since some base period
• St St . (1i)t / (1i)t
• where idomestic expected inflation rate i
  foreign expected inflation rate
• Empirical evidence of PPP
• General consensus holds up well in the long
  run, nut not over short time periods.
• Empirical support for the existence of
  mean-revering behavior of exchange rates.
• See graphs in Shapiro

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1.2. Fisher Effect (FE)

• Definition
• The Fisher Effect states that nominal interest
  rates in each country are equal to the required
  real rate of return plus a compensation for
  expected inflation.
• That is (1 nominal interest rate) (1 real
  rate) (1 exp. inflation)
• Or, in approximation r a i r a i
• Empirical tests show that the Fisher effect
  generally exists for short-maturity government
  securities, but are inconclusive for longer
  maturities.
• The generalised version of the Fisher effect
  asserts that real returns are equalised across
  countries through arbitrage, that is a a
• Significant real interest rates differential can
  only subsist in case of capital markets
  segmentation (see part 2 of the course)

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1.3. International Fisher Effect (IFE)

• Definition
• The International Fisher Effect (or Fisher-open)
  states that the spot exchange rate should change
  in an amount equal to but in the opposite
  direction of the difference in interest rates
  between countries.
• That is
• Or, in a simplified form over a single period

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1.3. International Fisher Effect (IFE)

• Interpretation
• Justification for the international Fisher effect
  is that investors must be rewarded or penalized
  to offset the expected change in exchange rates.
• Combination of PPP and FE.
• Arbitrage between financial markets should ensure
  that interest rate differential between any two
  countries is an unbiased predictor of the future
  change in the spot rate of exchange (but not
  necessarily an accurate predictor).
• Implicit assumption foreign and domestic assets
  are perfect substitutes.

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1.3. International Fisher Effect (IFE)

• Empirical evidence
• Empirical tests lend some support to the
  international Fisher effect, despite large
  short-run deviations.
• Holds also in the short run for nations with very
  rapid rates of inflation.
• Some criticism comes from studies suggesting the
  existence of a foreign exchange risk premium for
  most major currencies.
• Deviations can come from the reasons of changes
  in nominal interest rates either in real
  component, or due to changes in expected
  inflation.
• Also, speculation creates distortions in currency
  markets.

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1.4. Interest Rate Parity Theory (IRP)

• Covered Interest Rate Parity Definition
• IRP states that returns between assets in
  different countries should be equalised. If they
  are not, equalisation is brought by arbitrage.
• It gives
• (1rt) . Ft (1rt).St
• Return of foreign investment return of domestic
  investment
• where
• rt foreign interest rate
• rt domestic interest rate
• Ft forward exchange rate
• St spot exchange rate

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1.4. Interest Rate Parity Theory (IRP)

• Interpretation
• The movement of funds between two currencies to
  take advantage of the interest rate differentials
  is a major determinant of the spread between
  forward and spot rates.
• The forward discount or premium is closely
  related to the interest rate differential between
  both currencies.
• If Ft S.(1rt)/(1rt) , the fwd discount or
  premium covers the interest rate differential,
  and the fwd rate is said to be at interest rate
  parity.
• No possibilities of arbitrage left then on the
  money market (see further the currency risk
  hedging)

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1.4. Interest Rate Parity Theory (IRP)

• The Forward Rate
• A forward rate is an exchange rate quoted today
  for settlement at some future date
• The forward exchange agreement between currencies
  states the rate of exchange at which a foreign
  currency will be bought or sold forward at a
  specific date in the future (typically 30, 60,
  90, 180, 270 or 360 days)
• The forward premium or discount is the percentage
  difference between the spot and forward rates
  stated in annual percentage terms
• Fwd premium or discount (Fwd - Spot)/Spot
  360/n days of fwd contract

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1.4. Interest Rate Parity Theory (IRP)

• Hypotheses
• Assets same risk, same maturity
• No transaction costs
• No information costs
• No control on capital flows
• Plus, the transaction in the forward market
  implies that there is no foreign exchange risk
  (risk that S changes while investing abroad).
• Arbitrage Ex. return greater abroad, we have
• (1rt) . Ft/St gt (1rt)
• -gt Investors will sell spot rate and buy forward
  (to invest abroad), causing S to rise and F to
  fall, getting back to equality.

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1.5. Forward Market for foreign exchange

• Speculation
• Next to arbitrageurs, another important group on
  the forex markets speculators.
• They deliberately expose themselves to exchange
  rate risk.
• Speculators will trade on the basis of the
  difference between f (forward) and se (spot
  expected) at a given time horizon.
• Trade until f se

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1.5. Forward Market for foreign exchange

• Speculation - Example
• If f gt se, speculators will buy large amounts of
  fwd contracts, to sell spot at the end of the
  period, with an expected profit (f - se) x n
  contracts.
• Example fUSD 3 mths 1.37 / seUSD 3 months
  1.30 / gt buy large amount of against at 3
  months. In 3 months buy the fwd at 1.37
  (0.73) and resell them on the spot market at
  1.30 (0.77). Profit 0.04 per .

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1.5. Forward Market for foreign exchange

• Leads to the unbiased nature of the forward rate
  (UFR)
• f se
• Hypotheses underlying this relation
• Speculators are risk neutral
• Not prevented from operating on the forward
  market
• No transaction costs

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1.5. Forward Market for foreign exchange

• Unbiased estimator
• With raional expectations hypothesis we have
• st ste ut , ut being a random walk (µ0)
• with the arbitrage relation se f
• we have st ft-1 ut (1)
• meaning ft-1 non biaised estimator of St
• (1) is the efficient market condition relating
  the actual spot exchange rate to the forward
  rate.

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1.5. Forward Market for foreign exchange

• Econometrical testing over market efficiency of
  fwd rates
• Difficulty joint test, both on market
  efficiency and on fundamentals of the model
  supposed to derive se
• Methods using regressions and serial
  autocorrelation tests
• Some results of the econometrical tests
• Empirical support of existence of a risk premium
  (time-varying), but no clear model of formation.
• The lagged spot rate (st-1) outperforms the
  forward rate at predicting the spot rate -gt
  abnormal profits could have been made, trading on
  the basis of the difference between the current
  spot rate and the forward rate at a given time.

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1.5. Forward Market for foreign exchange

• Survey data about expectations formation of
  agents
• Expected change in spot rates is not an unbiased
  predictor of actual change in the spot rate.
• Agents bias their estimation of spot rates, based
  on extrapolation of recent trend -gt destabilising
  expectations on exchange rates.

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1.6. Summary of Section 1

• Some results
• Serious theoretical questions on PPP theory and
  few empirical support.
• IRP theory includes the role of capital mobility
  and arbitrage.
• Relationship between spot and forward rates
  suggest the existence of a time-varying risk
  premium and some irrationality of market
  participants while forming expectations of
  exchange rates.
• The existence of a risk premium states that
  assets domestic and abroad are not perfect
  substitutes, and that interest rates in any
  country may not be identical to those abroad,
  even with no particular expectations of spot rate
  changes.

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2. Balance of Payments

• General idea FX rates are adjusted so that the
  BOP is in equilibrium
• Definition
• Balance of paiements sum of all the
  transactions between the residents of a country
  and the rest of the world
• BOP current account balance capital account
  financial account changes in reserves
• BOP (X - M) (CI - CO) (FI - FO) FXB
• Current account exports - imports of goods
  services
• Capital account capital inflows - capital
  outflows capital transfers related to purchase
  and sale of fixed assets.

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2. Balance of Payments

• Balance of Payments (BOP) - Definition
• Financial account financial inflows - financial
  outflows net foreign direct investments net
  portfolio investments
• Current Capital Financial accounts Basic
  balance
• FXB changes in official monetary reserves
  (gold, foreign currencies, IMF position)
• Current account balance (X-M)
• In equilibrium X-M 0
• Deficit country X-M lt 0
• Surplus country X-M gt 0

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BoP - Examples
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BoP - Examples
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2. Balance of Payments - Adjustement
Domestic price of foreign exchange
Supply of foreign exchange (due to X) D of
domestic curr.
Seq
Deficit M gt X
Demand for foreign exchange(due to M) S of
domestic curr.
X
M
Q of foreign exchange
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2. Balance of Payments - Adjustment

• Deficit country (current account deficit)
• X - M lt 0 too many imports compared to exports
• Money supply gt money demand (in domestic
  currency)
• Too large amount of domestic currency
  deflationary pressures
• Surplus country (current account surplus)
• X - M gt 0 too many exports compared to imports
• Money demand gt money supply (in domestic
  currency)
• Lack of domestic currency inflationary pressures

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2. Balance of Payments - Adjustment

• S FX rate P/P amount of domestic currency
  per one unit of foreign currency. Ex. / S for
  Europeans. A depreciation of the domestic
  currency a rise in S.
• Ex. S0 1, S1 0.9
• S1 excess of demand deficit of BOP (too many
  imports).
• A depreciation makes foreign goods more
  expensive, and D decreases to equilibirum.

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2. Balance of Payments - Adjustment

• In case of floating exchange rates
• Deficit countries FX rates are expected to
  depreciate, due to the excess supply of money.
• Surplus countries FX rates are expected to
  appreciate, due to the relative shortage of
  domestic currency.

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2. Balance of Payments - Adjustment

• In case of fixed exchange rates
• Government in charge of the BOP equilibrium
• FX rates maintained via the change in currency
  reserves
• In case of deficit the central bank ease
  devaluation pressure by buying the domestic
  currency and selling foreign currencies (out of
  its reserves) and gold. If the imbalance is too
  large and the central banks run out of reserves,
  the domestic currency will devalue.
• BOP imbalances are then used to forecast the
  evolution of FX rates. Ex. the Thai Baht.

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2. Balance of Payments - Adjustment

• In case of managed floats
• Changes on relative interest rates to influence
  the capital inflows or outflows impacting the BOP
  and the valuation of a currency.
• Ex rise in interest rates to increase money
  demand (capital inflows) and support the value of
  the currency. BOP trends helps forecasting such
  moves.

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2. BoP - FX Policy Implications

• Possible policies for a deficit country
• let the FX rate depreciate and restore
  competitiveness, leading to a rise in X and a
  reduction in M (if FX rates are floating)
• reduce the stock of money by direct intervention
  buy domestic currencies against foreign
  currencies held in monetary reserves (if FX rates
  are fixed)
• increase interest rates to attract capital
  inflows (financing the deficit) and to reduce
  demand for imports (monetary view)

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2. BoP - FX Policy Implications

• Possible policies for a surplus country
• let the FX rate appreciate and decrease
  competitiveness, leading to a reduction in X, and
  an increase of M
• increase the supply of money by direct
  intervention sell domestic currencies and buy
  foreign currencies, growing the monetary
  reserves, to avoid FX appreciation
• increase the supply of money and sterilise to
  avoid a price rise exchange M1 and M3 sell
  government bonds against domestic currencies.
• lower interest rates to discourage capital
  inflows (increase outflows) and to reduce
  financial surplus

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2. BoP - FX Policy Implications

• Difference in the available policies of countries
  in deficit and in surplus in case of fixed
  exchange rates
• A country in deficit is forced to adjust
  (otherwise he runs out of reserves)
• A country in surplus is not forced to adjust
  can build up reserves and sterilise to avoid an
  increase in prices
• Called the asymmetry between deficit and
  surplus countries
• Will lead be the cause of one of the biggest
  benefit of the European Monetary Union

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3. Assets Models - Equilibrium

• Setting the equilibrium Spot Exchange Rate
• In freely floating exchange rates, the
  equilibrium spot rate is the market clearing
  price, that is, the FX rate that equates supply
  and demand of one currency against another.
• Factors affecting supply and demand of two
  currencies
• Relative inflation rates
• Relative interest rates
• Relative Economic Growth rates
• Political and Economic risk
• to read Shapiro, chapter 2.1.

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3. Assets Models - Expectations

• Expectations and the Asset Market Model of
  Exchange Rates
• Role of expectations due to the fact that
  currencies are financial assets, and an FX rate
  is simply the relative price of two financial
  assets.
• Assets prices are influenced mostly by peoples
  willingness to hold the existing quantities of
  assets, which in turn depends on their
  expectations on the future worth of these assets.
• The asset market model of exchange rate
  determination states that the exchange rate
  between two currencies represents the price that
  just balances the relative supplies of, and
  demand for, assets denominated in those
  currencies.
• Consequently, shifts in preferences can lead to
  massive shifts in currency values (cfr. financial
  crises).
• to read Shapiro, chapter 2.2.

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3. Assets Models - Expectations

• Factors affecting expectations on currency values
• The nature of Money
• 2 roles store of value and store of liquidity
  (1) depends primarily on the countrys future
  monetary policy (2) depends mostly on economic
  prospects and political and economical stability.
• Central Bank reputation
• Money can be viewed as a brand-name product whose
  value is backed by the reputation of the central
  bank that issues it.
• Underliying these reputation is trust in the
  willingness of the central bank to maintain price
  stability.
• Price stability and Central Bank independence
• Central Banks under political pressure might be
  pushed to monetize the deficit, that, to print
  money to finance it, leading to higher inflation
  and devalued currency.

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3.bis Other approaches

• None of the models developped so far succeed to
  explain FX rates levels and volatility
• No pattern found in FX behavior
• Volatility of FX rates much higher than the
  fundamentals
• -gt several models tend to explain the excessive
  volatility
• Dornbush overshooting model
• Portfolio approach
• News
• Bubbles
• Heterogenous expectations
• Chaos theory
• etc.

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3.bis News approach

• Testing models - News approach
• Try to distinguish between expected / unexpected
  components of exchange rates determinants
• Models sensitive to the way news are constructed,
  and to the choice of the type of news
• Poor empirical performance
• -gt research question what type of news is
  important to influence expectations on exchange
  rates?
• Empirical findings large role of mimetism in
  dealing rooms (SBS final dissertation, 2004)

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3.4. Misalignments / Speculation

• Misalignment departure of exchange rate from
  its long-run equilibrium
• Heterogeneous expectations models are an attempt
  to explain misalignments of FX rates
• Wide dispersion of opinions observed, in
  particular for longer maturities
• Model of two groups of forecasters (Frankel
  Froot, 1987)
• Chartists extrapolate past experience
• Fundamentalists using Dornbushs overshooting
  model
• Portfolio managers use a weighted average of
  these two forecasts, and update the weights
  according to who is doing better.
• Broad empirical support explained the rise and
  fall of the dollar in early 1980s.
  Questionnaires among forecasters supported the
  approach.

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4. Currency forecasting

• Requirements
• Given the efficiency and unpredictability of the
  FX markets, currency forecasting can lead to
  persistent profit only of the forecaster meets at
  least one of the following criteria
• Exclusive use of a superior forecasting model
• Consistent access to information before other
  investors
• Exploitation of small, temporary deviations from
  equilibrium
• Ability to predict the nature of government
  intervention in the foreign exchange market

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4. Currency forecasting

• Types of forecasts
• Market-based forecasts
• Forward rates f se
• Interest rates for predictions beyond one year,
  or for currencies with no forward markets
• Model-based forecasts
• Fundamental analysis examination of the
  macroeconomic variables and policies likely to
  influence a currencys prospects. Simplest form
  PPP.
• Technical analysis exlusive focus on past price
  and volume movements charting and trend
  analysis.
• Model evaluation
• Two criteria accuracy and correctness. And
  trade-off with simplicity and cost.