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IBUS 302: International Finance

Topic 1 –Introduction Lawrence Schrenk, Instructor

Introduction

 IBUS 302: International Finance  Lawrence P. Schrenk, Instructor  Course Page http://auapps.american.edu/~schrenk/IBUS302/IBUS302.htm

 Syllabus (Next Class)

Learning Objectives

Decide whether this is this the appropriate course for you.

Understand the importance of international finance.

Explain the features unique to international finance. ▪

The Contract

Why Study International Finance? Your Career

  “The number of CEOs with international experience rose in 2004 to 33 percent from 30 percent in 2003 and 21 percent in 2002. Among the top 100 CEOs, 41 percent have spent time abroad.” source “The Global CEO: Overseas Experience is Becoming a Must on Top Executives' Resumes.” source

A Simple Example

  Your firm plans to sell $1 million in products to a firm in England, the pound is currently valued at $2.00, and payment will be made in 3 months –so your buyer is expecting to pay £500,000 in 3 months.

Where is the exposure to foreign exchange risk?

▪  The risk is that the rate of exchange will change between now and the date of payment. ▪

Who will Bear the Risk?

 1.

There are three possibilities: You bear it by accepting a payment of £500,000 in 3 months.

The buyer could bear it by agreeing to pay $1,000,000 in 3 months.

 3.

You could hedge the risk by entering a contract to receive $1,000,000 for £500,000 in 3 months. ▪ What are the implications of each choice? ▪

Overview

Similarities Differences Trends

Overview: Similarities

 The basics principles of finance apply to international finance: ▪     The NPV and IRR Rules Stockholder Wealth Maximization The Benefits of Diversification Etc. ▪

The Differences

Political Risk Increased Opportunity Set Market Imperfections Foreign Exchange Risk

1. Political Risk

 Description: The possibility that sovereign governments makes

unexpected changes

in:     The movement of goods, capital, and people across their borders, The regulatory framework, Tax rates and codes, Etc.

Political Risk: Measures

1. Somalia 2. Sudan 3. Zimbabwe 4. Chad 5. Iraq 6. Dem. Rep. of the 7. Afghanistan 8. Côte d'Ivoire 9. Pakistan 10. Central Africn

The Failed States Index: Most Vulnerable Countries 2008

11. Guinea 12. Bangladesh 13. Burma 14. Haiti 15. North Korea 16. Uganda 17. Ethiopia 18. Lebanon 19. Nigeria 20. Sri Lanka 21. Yemen 22. Niger 23. Nepal 24. Burundi 25. Timor-Leste 26. Republic of the 27. Kenya 28. Uzbekistan

Political Risk: Management

 Difficulties ▪     Idiosyncratic Measurability Prediction Hedging ▪

2. Increased Opportunity Set

 Description: Possibility of additional investments, markets, sources of capital, etc.

 Possible Benefits     Investments: Higher Return, More Diversification Markets: Greater Selling Potential Capital: Lower Cost of Capital Human Capital: More Resources

International Correlation U.S. Can U.K. 0.64 0.61

0.50

0.36

0.44 0.51

0.32 0.33

0.55 0.54

0.43

0.69

Sing g 0.26 0.26 0.38

0.51

0.33

0.49 0.52 0.51

0.52 0.48 0.49 0.59

Ger Fra Swit 0.78 0.64

0.61

0.36

0.41

0.50

0.20 0.31

0.44

0.25 0.32 0.34

0.25 0.31

0.46

Jap Aus Hon g 0.25 0.34

0.47

0.29 0.37

0.65

– Meric, Ilhan and Gulser Meric. “Correlation Between the World's Stock Markets Before and After the 1987 Crash.”

Journal of Investing

7.3 (Fall 1998): 67 f.

3. Market Imperfections

 Description: Any condition that restricts the free flow of trade, capital, investment, profits, etc.

    Political: Corruption Legal/Regulatory: Discriminatory Taxes Social Culture: Attitudes to Inflation Business Culture: Alternate Goals

4. Foreign Exchange Risk

 Description: The possibility that the value of an investment, cash flow, return might change due to changes in exchange rates for currencies.

Some Historical Data Dollar/Pound Exchange Rate

Napoleonic

1791-2007

Wars and Great Depression War of 1812 American Civil War WW I WW II $12.00

$10.00

$8.00

$6.00

$4.00

$2.00

$0.00

Date

The Trends

Global Financial Markets The Euro ( €) Liberalization and Integration Privatization

1. Global Financial Markets

 Description: Inter-country integrated capital and financial markets with minimal trade barriers.

▪   Financial Innovation Technology –Computers + Internet   Electronic Trading 24/7 Trading ▪

The ‘Big Bang’ FTSE 100 1985-1987

The 'Big Bang' 3000 2500 2000 1500 1000 500 0

The ‘Big Bang’

22 (of 33)

2. The Euro ( €)

 Integration ▪  European Central Bank (ECB)    Unified Monetary Policy Macroeconomic Stability National Inflexibility   Currency Risk Transaction Costs ▪

The Eurozone

 Austria  Belgium  Cyprus  Finland  France  Germany  Greece         Ireland Italy Luxembourg Malta The Netherlands Portugal Slovenia Spain

Benefits and Costs of the Euro

 Benefits   Reduce Transaction Costs Eliminate FX Uncertainty  Costs    No National Monetary Policy No National FX Control Asymmetric Shocks

3. Liberalization and Integration

 Increased Trade ▪  Reduced Tariffs  Competitive Advantage (Appendix)  Organizations   General Agreements on Tariffs and Trade (GATT) World Trade Organization (WTO) ▪

Exports

1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 A n e rg a n ti

Merchandise Exports

B ra l zi a C a n a d h C a in C ze ch R p e b u lic e G rm y n a u H g n ry a u K a w it e M xi co e N e th a rl d n s u R ssi n a e F e d ti ra n o h T a ila d n n U e it K d g in o d m n U e it d S ta s te 1995 2006

Exports Change in Merchandise Exports 1995-2006

600% 500% 400% 300% 200% 100% 0% A rg en tin a B ra zi l C an ad a C C ze hi na ch R ep ub lic G er m an y H un ga ry K uw ai t M ex N ic R o et he us si rla an nd s Fe de ra tio n Th U ai ni la te nd d K in gd U ni om te d S ta te s W or ld

Tariffs EU Average Applied Import Tariff Rates

12 10 8 6 4 2 0 Ores and metals Manufactured goods Chemical products Machinery, etc.

Other manufactured goods 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

4. Privatization

 Description: The transfer of ownership and control of a corporation from the state to private agents.

▪      Various Degrees of Privatization Governmental Revenues Foreign Ownership Multiple Processes Corruption ▪

Privatization Trends

 Dramatic rise in the number of privatizing countries, from 13 in 1988 to 43 in 1995.

  Latin America 49% (Average Value $68 million) East Asia 25% (Average Value $110 million)  Europe and Central Asia 17% (Average Value $11 million)  Other 12% – Mary M. Shirley. “Trends in Privatization.”

Economic Reform Today

1 (1998): 8-10.