Chapter 18 International Finance

International Finance

Business has become increasingly international

International business has changed from import/export to operating full-scale businesses in other countries.

Multi-national companies (MNCs) have worldwide operations

Investing in foreign securities is common

Globalization

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Currency Exchange

Companies expect to be paid in their home currency– Buying from a firm in another country

requires that country’s currency– A US department store importing British

sweaters must exchange dollars for British pounds

3

The Foreign Exchange Market

Organized to trade/exchange currencies – Network of brokers/banks based in financial

centers around the world

Exchange Rate Tables– State the price of one currency in terms of

another– Exchange rate tables show two reciprocal

rates for each currency, Direct Quote

Indirect Quote

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Exchange Rates

Concept Connection Example 18-1 Exchange Rates

An American retail store orders 500 sweaters from Britain costing £35,000, when the exchange rate is $1.5740 = 1£.

Store’s Cost is – £35,000 x $1.5740 = $55,090

Exchange rates affect both:• The volume of trade between the two countries• The cost of imported products in the US

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Exchange Rate Risk

Exchange rates move constantly

Exchange rate risk is the chance of a gain or loss from exchange rate movement that occurs during a transaction

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Exchange Rate Risk

Exchange rate movements affect the profitability of international transactions– British sweaters: Buyer ordered at $1.5740/£

for a cost of $55,090– If pay at $2.0000/£, order costs $70,000, and

buyer makes $14,910 less than expected– If exchange rate moves down store profits

This variability in cost/profit is exchange rate risk

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Spot and Forward Rates

Spot Rate – The exchange rate

for “immediate” delivery of currency

– Spot deliveries are made in two days

Forward Rate – The price of

currencies to be delivered in future

– Major currencies have well-developed forward markets for delivery 1, 3 and 6 months ahead

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Hedging with Forward Exchange Rates

Exchange rate risk can be hedged with forward contracts

Lock in exchange rates for anticipated foreign currency needs– Eliminates exchange rate risk – Accomplished by buying the currency at

the forward rate for future delivery

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Terminology of Exchange Rate Movements

When a currency becomes more valuable in terms of dollars, it is said to strengthen or rise against the dollar

When a currency becomes less valuable in terms of dollars, it is said to weaken or fall against the dollar

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Supply and Demand—The Source of Exchange Rate Movement

Origins of Supply & Demand for Foreign Exchange– Supply & demand stem from trade and the

flow of investment money between nations– Americans want a British product – British want an American product

Supply and demand curves that determine exchange rates are derived from each country’s demand for the other’s products

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Foreign Exchange: British Pounds and U.S. Dollars

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Foreign Exchange: British Pounds and U.S. Dollars

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Why the Exchange Rates Move

Exchange rates move in response to shifts in the supply and demand for currencies in the two countries – Preferences in Consumption– Government Policy– Economic Conditions– Speculation – Direct Government Intervention

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Governments and the International Monetary System

When a nation’s currency strengthens – Imported goods become cheaper – The nation’s exported goods become

more expensive in foreign countries

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Governments and the International Monetary System

A strong dollar makes imports cheaper improving our standard of livingBut it makes US products more expensive in other countries so people buy fewer and we manufacture less for export reducing employment

A weak dollar makes US products cheaper in other countries with the reverse result

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Governments and the International Monetary System

Exchange rates impact both employment and the general standard of living– Governments are interested in

maintaining a balance and sometimes intervene to keep rates within reasonable limits

– Buy and sell their own currencies

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The International Monetary System

Rules by which countries exchange currencies

A floating exchange rate system has been in place since the early 1970s – Floating Free market forces determine rates

Between 1945 and the early 1970s a fixed exchange rate system was used– Rates set by international treaty – Each country was required to hold its exchange

rate nearly constant relative to the US dollar– Proved unworkable post WWII

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Convertibility

Not all currencies are convertible– Can’t be exchanged for other currencies

at market-determined rates – The currencies of China and Russia have

historically been inconvertible

Inconvertibility is an impediment to international trade

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The Balance of Trade

The net financial flow between two countries from trade – If US imports > exports: A trade deficit

exists with that county– If imports < exports: A trade surplus

exists

A long-term deficit can significantly impair the deficit country’s economy

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International Capital MarketsInvestments in foreign countries are common today– Portfolio investments in foreign securities – Direct investments in plant and equipment

overseas

The US dollar has a unique status– It is the world’s leading currency– Often serves as “international money”– Many international contracts are denominated

in U.S. dollars even though none of the contracting parties are American

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The Eurodollar Market

Eurodollars are American dollar deposits in foreign banks

The Eurodollar market is created when banks lend deposits to international businesses and foreign governments– Borrowers use Eurodollars

To pay for U.S. exports

To invest in American stocks and bonds

As a medium of exchange

Deposits are not just in European banks

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The International Bond Market

International Bond– Sold outside the home country of the

borrower

Foreign Bond– Issued by a foreign company but

denominated in local currency

Eurobond– denominated in a currency other than

that of the country in which it is sold

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Eurobonds

Most are denominated in U.S. dollars

Advantages to foreign buyers– Securities regulations in foreign

countries require less disclosure – Issued in bearer form–Most governments don’t withhold

income taxes on Eurobond interest

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Political RiskThe chance that a foreign government will expropriate property or that terrorists will destroy it

Other value-reducing foreign risk exposure:– Raising taxes– Limiting the amount of profit that can be withdrawn – Requiring the purchase of key inputs from local

suppliers – Limiting the prices of products sold within the country– Requiring part ownership by citizens of the host

country

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Transaction and Translation Risks

Transaction gains/losses – Arise from exchange rate changes that occur during

current international transfers of money– Have real profit, cash flow and tax impact

Translation gains/losses – Arise when assets and liabilities held in a foreign country

are translated for consolidation on a parent company’s books in its home currency

Relevance of Translation Gains and Losses– Translation gains/losses only exist on paper

Not “realized”

– Shown cumulatively as an adjustment to equity– Not taxable since not realized

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Free Trade, the Theory of Comparative Advantage, and Protectionism

Free Trade – Implies that firms

in both countries are free to market or manufacture their products in either country

Protectionism – Exists when one or

both countries pass laws to limit or prohibit importing goods and foreign business ownership

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The Theory of Comparative Advantage

A two country–two product community will be better off if each nation specializes in what it does best and buys the other product from the other country

Comparative Advantage is a powerful argument for free trade in the long run

But there is a great deal of economic pain among workers and investors in the short run

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GlobalizationA general movement of the world economy toward free trade – Along with an increase in international

business– Governments are promoting the process

Proponents say increased production due to unrestricted trade leads to a higher standard of living for everyone

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Anti-GlobalizationMost agree on the comparative advantage benefit of free trade: More total production….BUTNot all agree globalization is a good thing– Free trade includes putting factories in poor

countries, paying extremely low wages, and making huge profits on the cheap labor

Many say this amounts to exploitation of underdeveloped countries

Opponents also maintain that it leads to– A widening gap between rich and poor – Excessive corporate power

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The Migration of Jobs Outsourcing

Today outsourcing means moving work overseas– Leads to a loss of jobs at home– Originally limited to low end jobs

But outsourcing of knowledge-based jobs began in the 1990’s– Certain low wage nations have some

highly educated people e.g., India– Technology is making it possible to

transfer knowledge functions electronically

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Labor Migration and Illegal Immigration

Developed countries often lack the people to do low-end jobs– Creates incentives for labor migration from

undeveloped countries

The problem is serious in US due to the historical ease of entering the country and staying without permission– 11.5 million illegal immigrants– Currently a major political problem

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The Balance of Trade with China and its Inconvertible Currency

China has moved towards a free market economy in the last 30 years

An undervalued currency makes Chinese products extremely cheap in US– Inconvertible – Exchange rate doesn’t float– 40% price advantage over US manufacturers– Trade deficit of more than $280 billion per year– A conservative U.S. government maintains the

low prices of Chinese goods benefit Americans– Another major political issue

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Sovereign DebtSovereign governments collect taxes and spend on services– If spending exceeds taxes have a deficit and

gov’t borrows by selling bonds

Deficits accumulate into national debts– Interest also paid out of taxes

In a recession tax income falls but services and interest continue – Gov’t depends on continued borrowing.– Investors recognize weakness and stop lending– CRISIS – Government may fail

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European Sovereign Debt Crisis

At least 5 of 17 Eurozone countries are facing financial crises– Could cause governments to fail

Started with the post 2008 recession

Important Note: Eurozone countries give up an economic control when join the zone.– Can’t print money to pay on national debts.

Troubled countries are– Greece, Ireland, Italy, Portugal and Spain

Banks and ContagionWhen a bond issuer is in financial trouble the value of its existing bonds falls

European banks invest in those bonds so their assets shrink when countries are in crisis.– Banks fail if the value of their assets falls too far– Banks holding sovereign debt are all over Europe

The failure of a country in crisis can trigger bank failures across Europe– Banks stop lending– Lack of commercial credit deepens the recession

Hence we say the crisis is contagious

Actions to Combat the Crisis

Stronger Eurozone countries (largely Germany and France), the European Central Bank (ECB), and the IMF have contributed to several bailouts of Greece and other troubled countries.– Demanded cuts in gov’t spending in those countries– Austerity programs – Not popular with populations

European Financial Stability Facility was set up to provide emergency lending.

Tensions in the Eurozone

People in the healthy economies, are tired of pouring money into failing countries

People in crisis countries resent austerity programs forced on them

Financial experts say there’s as much as a 75% chance that at least one country will exit the zone.