International Finance Lecture 1
Course Overview:
Theory of Trade
MNC
Gold Standard
Monetary Union
Understanding Exchange Rate Regimes
Exchange Rate Regimes
Currency Crisis
Macro-Economic
Determinants
Fixed vs. Floating
Laws Binding
Spot Rates
Market Types
Financial Market Structure
Instruments
Players &
Organization
Bonds
Forwards
Exchange Rate Behavior
PPP, CIPC
Fisher Eqn.
Implications for future rates
FX Derivatives and Use in Hedging
Futures, Options,
Swaps
Strengths & Weaknesses
FX Risk Types and Hedging
Limitations
Alternative Hedging
Techniques
Netting, Counter-trade,
Transfer Pricing…
Transaction Risk
Operating Risk
Translation Risk
Limitations
Other FX Management Issues
International Finance Lecture 1
Introduction:
1. International Finance
a. Corporate Finance for management of international investments
b. More than just corporate finance with exchange rates:
 Currency Risk—uncertainty surrounding future exchange rates
 Risk from non-financial factors such as nationalization, failure to
enforce patent & copyright laws, foreign legal risks
 Capital Barriers and Differential Taxes
 Financial hedges (Derivatives) to reduce currency risk
 Pricing structures to reduce taxes or circumvent capital controls
 World-wide alternatives for raising/employing capital
2. Multinational Corporations (MNC)
a. Firm that has production and sales in more than one country.
b. Permits efficient distribution of manufacturing and has access to a broader
customer base.
c. Is able to shift both production and sales activities in response to market
shifts.
d. More than 60,000 MNC’s world wide producing 25% of global output
e. By country of origin: US, Japan, France, Germany, and UK have the
largest MNC’s.
f. Over 1990’s FDI by grew at 3 times the growth rate of international trade
g. Examples: GE, Exxon, Shell, Ford, Toyota, Daimler-Chrysler, etc.
3. Market Imperfections
a. MNC’s exist to take advantage of market imperfections:
 Minimizing labor costs
 Minimizing corporate taxes
 Taking advantage of Tariffs, Quotas, and other trade restrictions
 Circumventing Capital Restrictions
 Pricing in accordance with a country’s wealth
 Moving production to countries with the VAT (reduces taxes on
exports)
b. Additional Risks:
 Future Foreign Exchange rate uncertainty
 Political (e.g. nationalization) and Legal Risks
International Finance Lecture 1
4. WHY COUNTRIES TRADE:
 Theory of Comparative Advantage—countries should specialize
in the goods they produce efficiently, and trade.
 Increases total world production.
Example: Suppose there are only two countries and two goods in the world.
- Australia can produce 800,000 rifles or 300,000 computers
- Singapore can produce 500,000 rifles or 250,000 computers
- Australia needs 300,000 computers, the rest can be rifles
Without Trade
Australia
Singapore
Total:
Rifles
0
500,000
500,000
Computers
300,000
0
300,000
With Trade
Australia
Singapore
Total:
666,667
0
666,667
50,000
250,000
300,000
5. Events/Trends leading to Globalization
a. Deregulation of International Financial Markets
 Japan opened FX markets to foreign brokerages in 1980
 London (LSE) opened to foreign bank membership in 1986
 Repeal of Glass-Steagall in 1999
 Opening of developing markets via the easing of investment
restrictions to facilitate FDI—foreign ownership
 Multinational Corporations issuing globally traded shares
 International Trade growing (exceeds 20% of World GDP)
 Merger of NYSE and EuroNext Stock Markets 2006
b. Introduction of the EURO and the formation of the European Union in
1999.
b. Privatization
 Globally, developing countries divesting state owned industries
 Provides capital to payoff external debts
 Increases production efficiency by as much 20% (more?)
 Provides foreign investment opportunities
International Finance Lecture 1
History of the International Monetary System:
1. Bimetallism/Gold Standard
a. Originally coinage in silver and gold
b. Bimetallism fell out of favor and Gold Standard created (where notes
were backed by a certain ratio of gold)
c. Suspended by most nations in 1914 (WW I)
d. Restored in 1928, but dropped by most economies in 1931-36 because of
inability to control gold outflows during financial crises.
2. Drawbacks of Gold Standard
a. Fixed amount of gold—Currency does not grow with economy
b. Leads to deflation in growing economies
c. Exchange rates fixed:
i. Prices of goods must adjust to compensate for trade imbalances
ii. Problem is that prices are sticky. Sticky prices in a deflationary
economy result in lower demand levels and thus, unemployment
UK
£ MS ↓
Prices ↓
UK has a trade
deficit with France
Gold Transferred
France
French MS ↑
Prices ↑
Because of rising
prices in France,
trade imbalance
disappears.
3. Bretton Woods (1944)—the last Gold Standard:
a. Reinstituted Gold Standard
b. Pegged the US dollar at $35/oz. gold—US would hold world’s gold
c. Other central banks to hold US dollar as reserve currency in lieu of gold
d. Exchange rates fixed against US dollar
e. Problem—fixed amount of gold when growing economies require
increasing currency reserves
i. Increasing Reserves devalues the US dollar against gold
ii. Because of fixed exchange rates, the Dollar becomes over-valued
in terms of the other currencies (Frank, Deutschmark, Pound)
f. In late 60’s and early 70’s, US government loosened monetary policy to
pay for Vietnam conflict
i. Foreign central banks forced to purchase excess US dollars to
maintain fixed rate parities
ii. Exported inflation to other nations through fixed exchange rates
g. Attempted to salvage system by revaluing dollar to $38/oz. (Smithsonian)
h. System collapsed to floating rates (1973)
International Finance Lecture 1
4. Flexible Exchange Rates (Present System)
a. Floating rates that are supply/demand based
b. Central banks may intervene to calm transient disturbances (e.g. 9/11)
c. Gold officially abandon as reserve asset—currency now represents a
claim on the economy
d. Drawbacks:
i. Greater exchange rate volatility
ii. Uncertainty surrounding the future exchange rate—interferes with
financial planning
e. Louvre Accord (1987)
i. Coordination among G-7 countries to coordinate monetary policies
to achieve greater exchange rate stability
ii. Louvre Accord is de-facto a managed-float arrangement
5. Exchange Rate Arrangements:
a. Dollarization—Using another countries currency as legal tender
b. Currency Board—Peg with a legal obligation
c. Fixed Rate (Peg)
d. Pegged with horizontal bands
e. Crawling Peg
f. Crawling Bands
g. Managed Float
h. Independent Float
No Freedom to conduct
Monetary Policy
Complete Freedom to
conduct Monetary Policy
6. EU and the European Monetary System
a. Originally 6 nations, now 27 (Croatia, Macedonia, Turkey are candidates)
b. Purpose: facilitate trade and labor flows, and economic development
c. Creates a Common Market exceeding the population of the US
d. Effectively creates a United States in Europe with:
- Ease of cross-border transactions
- Ability of labor to move where needed
7. Introduction of the EURO
a. Common currency binding 15 nations (Not all EU members use the
EURO, notably UK, Sweden, and Denmark)
b. Facilitates Cross-border Transactions and Investment by eliminating
exchange rate risk
c. Consistent Monetary and Fiscal Policy for members
d. Compete as a Reserve Currency—creates currency stability
e. Countries wishing to adopt the Euro must meet “convergence criteria”:
i. Deficits and Public Debt
ii. Price Stability (Inflation)
iii. Keep individual currencies within prescribed exchange rate bands
f. European Central Bank solely responsible for of monetary policy, National
Central Banks in each country behave like regional FED’s
International Finance Lecture 1
Appreciation of the Euro:
Pacific FX Plot © 2009 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada
8. Benefits of Monetary Union
a. Facilitate Cross-border Transactions and Investment
i. Eliminate exchange rate risk and need for forecasting
ii. Permit Business Decisions to be made solely on economic grounds
iii. Increase Price Competition
iv. Eliminate costs of currency exchange
b. Benefits of a Major Reserve Currency
i. Stable exchange value
ii. Major holdings in Central Banks
iii. Simplify exchange with US and other countries
iv. Facilitate Capital Market Development for all members
9. Drawbacks
a. Limitations on Fiscal Policy for member nations (deficit spending)
b. No ability to use Monetary Policy
c. Example: France has 10% unemployment, it cannot use stimulative fiscal
or monetary policy
d. Free flow of labor may not correct problem
International Finance Lecture 1
Balance of Payments—Net Demand for a Currency:
10. Balance of Payments
a. Net Difference between the Supply and Demand for a Currency
b. BOP = 0 for a floating rate regime (why?)
 Rates adjust so that Supply Equals Demand
 The currency in Demand Appreciates vs. the other currency
c. Under Fixed Rates a Deficit or Surplus can persist
 Deficits must be financed through borrowing or
 The central bank will hemorrhage currency
d. BOP = Current Account + Capital Account
11. Current Account
a. Exports – Imports (Net Exports or NX)
b. Reflects imbalances in Trade
c. For instance if the US imports 200 million in goods, and exports 160
million, it has a trade deficit of 40 million (a negative balance)
12. Capital Account
a. Capital Inflows – Capital Outflows
b. Capital Inflows are investment from foreign entities
 Used to purchase factories, real property, and other productive
resources
 Composed of Direct and Portfolio Investment
c. A positive balance:
 More capital is entering the country than leaving
 Foreign investors are purchasing more of our productive
resources than we are purchasing of theirs
13. Implications of a Trade Deficit
a. Exports < Imports → Current Account < 0
b. Since BOP = 0, then Capital Account > 0
c. Thus:
i. We are selling our productive resources to pay for consumption of
foreign goods
ii. Selling our future to consume in the present
d. This will eventually lead to a currency depreciation—currently occurring
e. Deviation from this rule is when we are selling over-valued assets—e.g.
Japanese purchase of real-estate in 1980’s
International Finance Lecture 1
Budget Deficits and Implications for Currency Value (Exchange Rates):
14. Excessive Government Spending
a. Governments finance spending via two means—taxes and debt
b. Deficit Spending means that Spending exceeds Tax Revenues, or we must
issue debt to finance spending
c. Note—it does not matter what the spending is for; e.g. Social Programs,
Medicare, Education, Infrastructure, Military, War, Catastrophic Events
d. To attract purchasers for our debt, we must increase Treasury rates—this
can result in an immediate appreciation of the currency
e. However, over the long-run, higher interest rates mean higher inflation—
our currency devalues
f. Moreover, to continue deficit spending, we will have to continue raising
interest rates → currency will continue to depreciate
Graphic Model:
Prices
AD = C+G+I+NX
AS = f(I(r), L)
C—Consumption
G—Government
I—Capital investment
NX—Net Exports
L—Cost of labor
Real GDP
If Government Increases Spending: G↑
Prices
AD
AS



G↑ means AD shifts out
GDP↑ and Prices↑
Prices↑ means inflation, therefore
currency ultimately depreciates
Real GDP
Crowding out of Investment:
Interest Rates (r)
As Government borrows more
money, interest rates rise and
capital investment falls
Capital Investment (I)
Prices
AD
AS
Because of declining
investment, and
increasing wages, AS
shifts backward.
Real GDP
International Finance Lecture 1
Crowding out of Net Exports:
Prices
AD
AS
NX and Investment Falls as Prices Rise, thus AD
also gets shoved backward. The result is higher
prices than we started with (inflation), higher wage
rates, and less investment (economic growth)
Real GDP
15. What if foreign investors cease buying our debt?
a. Treasury rates skyrocket → Interest rates sky rocket
b. Capital Investment collapses
c. The currency plummets
d. Note: there is a binding relationship between the current spot, a country’s
risk-free rate (Treasury rate for the U.S.), and expected future spot (also
known as the forward)
Economic Shocks:
16. Economic Shocks
a. Can make a country richer or poorer
b. Improve or reduce productivity
c. Negative Shocks such as the destruction of a major oil field, will reduce a
country’s exports, its productivity, and reduce its productive capacity
d. Hence, demand for its currency will fall, and the currency will depreciate
Prices
AD
AS
Effect of a negative supply shock,
reduces productive capacity and
results in higher prices.
Real GDP
Depreciation:
17. What causes a currency to Depreciate???
a. Persistent Trade Deficits will cause a depreciation
b. Foreign Borrowing to finance Government Deficit Spending
c. Major Negative Economic Shocks reducing productive capacity—e.g.
9/11, Hurricane Katrina
International Finance Lecture 1
International Crisis: http://www.stern.nyu.edu/globalmacro/
18. Mexico January 1995
a. Facts
 40% Devaluation against US dollar
 Loss of 30 Billion in Foreign Reserves
 Financial Bail-out Package
 Crawling Band (Peg) arrangement—essentially fixed exchange
rates
b. Mexico losing reserves, why?
 Political assassinations and Perceived Political Instability
 Huge early influx of foreign investment financing consumption
c. De-regulation of Banks – Zero reserve requirement/Easy Credit Policies
 Excessive incentives to lend
 Lending increasing lower credit borrowers (high defaults)
d. Short term management of government debt
 Began issuing bonds in Denominated in US dollars (dangerous?)
 Lowered interest rates, but resulted in skyrocketing debt when
Peso devalued
e. The result for the Mexican economy was a massive recession
19. Asian crisis 1997-98
a. Thailand—Indonesia—Korea—Malaysia—Philippines
 Thai Baht devalues 20%, July 1997 (40% by December)
 Other currencies follow, Rupiah devalues by 80%
b. What was the cause of the crisis?
 High levels of foreign currency debt by firms and governments
 Excessive government spending
 Excessive investment beyond economically justified levels
 Lack of a Credit Culture at banks
 Political lending decisions
 Fixed exchange rates
c. Devaluation meant financial disaster
 Value of foreign denominated debt sky rockets
 Flight of investment capital
 Skyrocketing unemployment
20. Other Financial Crises—Common Components (The Big Picture)
a. Fixed rate arrangements have been a feature in most crisis
b. Excessive government spending—blossoming government debt
c. Large Amounts of Foreign Currency Debt—exacerbates crises
d. IMF typically provides a bailout package
e. Brazil, Argentina, Russia…
International Finance Lecture 1
21. The International Banking and Financial Crisis of 2008
a. There are several contributing factors to the crises:
i. Increased issuance of Sub-prime and Creative Mortgage Contracts
creating a real estate bubble
ii. Excessive Government Spending
iii. Excessive Consumerism driven by Loose Credit Policies, Lack of
Consumer Discipline, and Asset Overvaluation
iv. The Increased Footprint of Speculators in Financial Markets
v. The Decline of the US Industrial/Manufacturing Base
b. Creative Mortgage Contracts and The Real Estate Bubble
 Interest Only, Variable Rate, and Negative Amortization Loans
beginning 2000
 Extensive Sub-Prime Lending encouraged by Democrats in
Congress
 Resulted in home-buyers being able to borrow far more than with
Traditional Fixed Rate Mortgages
 Housing Prices climbed beyond long-run values
 Pyramid Scheme Collapses when Interest Rates Increase, and
borrowers are forced to refinance
 Risk Spread throughout Financial System when risky mortgages
used in normally sound CMO’s
c. The Role of Government Spending
 Increased Wartime Spending by Bush Administration, did not cut
other Gov’t Spending to compensate (LBJ)
 Deficit spending compounded by tax cuts
 The Result: Burgeoning Federal Deficits, exhausting access to
world credit
 Deprives the US of Credit to recapitalize of our banks
 Excessive Spending also Stimulates Excessive Consumerism
d. Excessive Consumerism and Easy Credit
 Strengthening of Bankruptcy Laws combined elimination of
Usury Laws has resulted in increased credit card issuance
 Likewise, the US consumer has become increasing predisposed
to living on credit
 Result is a negative savings rate, again reducing the country’s
potential credit reserve
 And, exacerbates the real-estate crises because of insufficient
household savings to make mortgage payments if laid off
International Finance Lecture 1
e. The Stock Market—The World’s Newest Casino
 Stock Market trades increasingly characterized by speculative
trading (technical trading)
 The result is increasing market volatility
 Inhibits traditional capital raising function of the market, crucial
to recovery from a recession
 Due to the decline in trading costs and increased use of program
trading/speculative strategies
 Further encouraged by real-estate bubble, in which consumers
borrowed against fictitious equity
f. Decline of US Manufacturing Base
 US has ceded much of its manufacturing base to China, India,
and several developing countries
 Result of economic specialization arguments that we pursue high
return services
 Problem is that services means we provide capital, and we are
now a debtor nation
 Will impede recovery because we have little to export, yet it is a
trade surplus that is needed to pay off US debt
 While this is not a direct cause, it threatens our recovery, and
contributed vastly to our trade deficit and exhaustion of world
credit
g. Contagion to Foreign Markets—why did it spread?
 UK/Europe had its own real-estate crises
 Foreign institutions held large quantities of US CMO’s
 The US is the chief export market for Asia and many developing
nations