International Financial Management FINA 4386 Introduction Shapiro Chapter 1

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International Financial ManagementFINA
4386Introduction(Shapiro Chapter 1)
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International Finance

• Why take such a course ????
• Study of finance
• Corporate finance
• Investments
• Institutional finance
• Where does International finance fit?
• Examples of corporations that are truly
  international ??

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• BPs stake in Russian oil firm effort to reduce
  dependence on middle east oil
• Exxon Mobil plans to spend 10 billion over the
  next 10 years exploring new oil reserves near
  West Africa
• Royal Dutch/Shell Group plans to start a
  multibillion dollar investment to boost reserves
  in Sakhalin, Russia
• Chevron-Texaco is looking at developing natural
  gas reserves in Venezuela (off the northeastern
  coast near Trinidad and Tobago)

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• World exports as of GDP 9.9 in 1970 to about
  16 in 1992
• U.S. Consumption imports increased from 7 in
  1962 to 17 in 1992
• Consumption patterns
• Cars (Germany and Japan)
• Oil (Middle East)
• Beer (Germany)
• Cheese and chocolates (Switzerland)
• Clothes (China, Hongkong, Thailand, Bangladesh,
  India)
• Computers (Taiwan, Korea)

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• Investment patterns
• In 1996, investment in global mutual funds was
  close to 150 billion
• Between 1970 and 1988 the proportion of US debt
  held by foreigners increased from 7 to 17
• Between 1974 and 1988 the proportion of German
  debt held by foreigners increased from 5 to 34
• Emerging market funds
• Foreign firms listing on US stock exchanges
• --ADRs (American Depository Receipts) A
  security issued in the United States to represent
  shares of a foreign stock, allowing that stock
  to be traded in the United States.

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• -- An ADR is issued by a U.S. bank, consisting of
  a bundle of shares of a foreign corporation that
  are being held in custody overseas.
• --Over 2000 ADRs listed in the U.S.

--
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• Example
• Film Total Recall was made by
• A Hungarian born producer
• A Dutch director
• Lead actor was Austrian
• Villain was a Canadian
• Film was shot in Mexico
• Distribution was done by a Hollywood studio that
  was owned by a Japanese firm

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• More choices such as exotic options on swaps
  (swaptions), options on futures
• More than 5 of the volume of U.S. treasury
  securities in 1994 were traded on the London and
  Tokyo markets - enhanced liquidity

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Globalization

• Increase Financial Integration
• Encourage Trade Liberalization and Economic
  Integration

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Financial Integration

• Decrease cost of capital
• Promote economic growth
• Spur financial innovations,
• --1960s
• Bank debt
• Investment grade bonds
• Common equity
• --Today
• Currency futures and options
• Multi-currency bonds
• Cross-border stock listings
• International mutual funds

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Trade Liberation and Economic Integration

• Evidence of trade liberation
• The General Agreement on Tariffs and Trade
  (GATT) a multilateral agreement among member
  countries has reduced many barriers to trade.
• The World Trade Organization has the power to
  enforce the rules of international trade.
• The North American Free Trade Agreement (NAFTA)
  calls for phasing out impediments to trade
  between Canada, Mexico and the United States over
  a 15-year period.
• For Mexico, the ratio of export to GDP has
  increased dramatically from 2.2 in 1973 to 28.7
  in 2001.

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The process of globalization

• Imports
• Early instances of globalization for raw
  materials - British East India Company
• Modern day examples of raw material seekers - BP,
  Standard Oil seeking sources of oil
• International Nickel, Kennecott Copper
• Seek access to cheaper sources of production
• Set up production facilities abroad
• Licensing - license a local firm to manufacture
  products
• Royalties

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The Multinational Corporation

• Parent company in the home country and
  subsidiaries abroad in various countries.
• There are about 60,000 MNCs in the world.
• Many MNCs obtain raw materials from one nation,
  financial capital from another, produce goods
  with labor and capital equipment in a third
  country and sell their output in various other
  national markets.
• Coca Cola earns more than 80 of its beverage
  profit abroad generates more revenues in Japan
  than in the U.S.

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The Multinational Corporation

• Ability to move resources and funds across
  countries
• Transfer prices on internal trades
• Intercompany loans
• Deal with the same issues as a corporate finance
  manager in a broader financial market with more
  participants
• Investment decisions
• Financing decisions
• Dividend (distribution) decisions
• Focus on the global financial market and
  participants and how they differ from a domestic
  market

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One example of such a difference - Rate of return

• Ex You are an American investor. You invest
  1,000 for one year in the German bond market.
  The current exchange rate is 1 Euro1.5
• The bond interest rate is 10
• Hence you can buy 1,000 x 1.5 Euro1,500 worth
  of German bonds
• One year from now you will have Euro1,500 x 1.1
  Euro1,650
• What is your rate of return?
• Depends.

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Depends on the exchange rate one year from now

• If the exchange rate one year from now is 1
  Euro2
• Your return translates to 825 (1650/2)
• Hence the rate of return -17.5
• If the exchange rate one year from now is 1
  Euro1.2
• Your return translates to 1,375 (1650/1.2)
• Hence the rate of return 37.5
• If the exchange rate one year from now is 1
  Euro1.5
• Your return translates to 1,100 (1650/1.5)
• Hence the rate of return 10

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Why do firms become Multinational?

• Market seeker U.S. automobile firms
  manufacturing in Europe for local consumption.
• Raw material seekers oil, mining, plantation,
  and forest industries.
• Production-efficiency seeker (or cost
  minimizers) Labor intensive production of
  electronic components in Mexico, China, Taiwan,
  Malaysia.
• Knowledge Seeker German, Dutch, and Japanese
  firms have purchases U.S.-located electronics
  firms for their technology.

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Top 10 MNCs
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International financial markets

• What constitutes international financial markets?
• (1) FX (Foreign Exchange) market
• Currency markets - exchange dollars for French
  francs of Mexican pesos or Thai baht or the
  Russian ????

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International financial markets

• (2) Euro markets
• Euro currency markets Markets for currencies
  outside their national jurisdictions e.g.
  Eurodollar markets are markets where you can buy
  or sell dollars but through banks outside the
  U.S. Banks in Europe that accept deposits and
  make loans in dollars
• Euro sterling, Euro yen etc.
• Use of these markets e.g. Japanese firm wants
  to borrow in yen and invest in dollars because of
  changes in interest rates between the dollar and
  the yen

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International financial markets

• (3) Domestic and International capital markets
• Domestic bond market IBM issues bonds in the
  U.S.
• Foreign bond market Mitsui Corp of Japan issues
  yen denominated bonds in the U.S.
• Eurobond market IBM or Mitsui issue dollar
  denominated bonds outside the U.S.

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International financial markets

• (4) Global derivatives market
• Forward market
• Futures contracts
• Options market
• Swap market

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International financial markets

• (5) International equity markets
• Corporations can now raise capital outside their
  national borders
• ADRs listed in the U.S. (Over 2000 of these
  www.bony.com)
• Commodities are becoming integrated into
  financing
• A Spanish utility can issue bonds in U.S. dollars
  or it can issue bonds denominated in oil I.e.
  have interest and principal repayments tied to
  the price of oil

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Study of international financial markets

• Determinants of prices on these markets
• Relation between spot rates and economic
  fundamentals
• Forward rates and economic fundamentals
• Relation between prices
• Parity conditions that give the relation between
• Spot and forward exchange rates
• Exchange rates and interest rates
• Exchange rates and prices
• Pricing Efficiency
• What does the pricing distribution look like?
• Are markets efficient in that price changes are
  random?

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Study of international finance

• Is a study of the factors that affect economic
  relations between nations
• Macroeconomic factors that affect exchange rates,
  interest rates, prices
• Effect of elections in Indonesia, family feuds in
  the Saudi royal family, labor strikes in Korea,
  nuclear tests in India, peace accord in
  Ireland...
• How do these factors affect a firms bottom line?
• Is a study of how these risks can be managed or
  reduced
• Hedging techniques available
• Imports and exports
• Futures and options

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Organization of the course

• FX Market
• Start with an overview of the systems of exchange
  rates - fixed versus floating
• Review the details of the foreign exchange market
• Parity conditions - Interest rate parity and
  Purchasing power parity
• Instruments available on the FX markets
  forwards, options, futures, swaps
• Multinational corporations and their exposure to
  foreign currency risk
• Nature of risks
• Measurement of risks
• Management of risks