Chapter 18 International Finance

1. Chapter 18 International Finance

2. 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

3. 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

4. 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

5. Exchange Rates

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. Foreign Exchange: British Pounds and U.S. Dollars

14. Foreign Exchange: British Pounds and U.S. Dollars

15. 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

16. 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

17. Governments and the International Monetary System • A strong dollar makes imports cheaper improving our standard of living • But 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

18. 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

19. 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

20. 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

21. 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

22. International Capital Markets • Investments 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

23. 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

24. 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

25. 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

26. Political Risk • The 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

27. 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

28. 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

29. 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

30. Globalization • A 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

31. Anti-Globalization • Most agree on the comparative advantage benefit of free trade: More total production….BUT • Not 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

32. The Migration of JobsOutsourcing • 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

33. 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

34. 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

35. Sovereign Debt • Sovereign 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

36. 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 36

37. Banks and Contagion • When 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

38. 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.

39. 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.