Finance Internationale

Pr. Ariane Chapelle Année académique 2004 - 2005

Contact: E-mail : [email protected]

Site web : www.solvay.edu/cours/chapelle

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Contents

•

Part 1 : Fundamentals of International Finance

–

1.1.Introduction the financial environment

 Types of currencies – –  Impossible Trinity

1.2. Exchange rate determination : family of models

 1. Parity Conditions  2. Balance of Payments approach  3. Assets Approach  4. Currency Forecasting

1.3. The Economics of Monetary Union

 The case for a greater fixity in exchange rates  Optimal single currency zone : criteria  Monetary integration in the European Union |

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•

Contents

Part 2 : International Corporate Finance

–

2.1. Foreign Exchange Exposure

 Transaction exposure – – –  Operating exposure

2.2. Financing the Global Firm

 Sourcing equity globally  Financial structure and international debt

2.3. Foreign Investment Decision

 FDI theory and strategy  Multinational capital budgeting  Adjusting for risk

2.4. Managing Multinational Operations

 Repositioning funds  Working capital management |

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References

• • •

Fundamentals :

– Shapiro, A., Foundation of Multinational Financial Management , Whiley ed., 2003, available on http://knowledgespace.solvay.edu

– See my bookshelve - Bookmarks on the Shapiro 2003

European Union :

– De Grauwe, P., The Economics of Monetary Union , Oxford University Press ed., 2003.

Part 2 :

– Eiteman, D., Stonehill, A. and Moffet, M., Gestion et finance internationale , Pearson Ed., 10e ed., 2004.

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Requirements

• • •

Prérequisites :

– – Good knowledge of Corporate Finance basics Some knowledge of Macroeconomics and Monetary Economics

Assignments (40% of final grade)

– – Every 2 weeks : 1-2 pages assignment to hand in for the following week, based on internet exercices from textbooks Syndicates of max. 2 students

Part 2 :

– Eiteman, D., Stonehill, A. and Moffet, M., Gestion et finance internationale , Pearson Ed., 10e ed., 2004.

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The international financial system •

Introduction

– Different forms of exchange rates organisation : –  fixed  floating  managed  monetary unions

Questions of

 adjustment of balance of paiements  liquidity provision in the system  international money definition and usage |

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The international financial system • Impossible Trinity :  Exchange rate stability  Full financial integration (free capital flows)  Monetary independence Full Capital Controls • •

Monetary Independence

Pure float Impossible Trinity

Full Financial Integration

Is there a best system?

What design of institutions?

Exchange rate stability

Monetary Union |

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The international financial system • •

International money

– Characteristics : International money should be :  defined  convertible  inspire confidence  store of value

Summary issues & concerns of financial markets :

– – Adjustments of BOP Provision of liquidity

4 different systems address these 2 issues.

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The international financial system

Four types of International Financial systems :

1.

Automatic mechanisms (of adjustments)  Pure floating rates : between the two World Wars 2.

3.

4.

 Pure fixed exchange rates : gold period (N-1) Systems  N countries linked to gold : a large country, its currency = international money  N-1 countries linked to N = fixed exchange rate regime : Bretton Woods Policy coordination & Multilateral mechanisms : SME Monetary union : EU |

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Automatic Mechanisms • •

Two mechanisms can be defined as fully automatic :

– – Freely floating exchange rate system Fully fixed commodity standard

Freely floating : no BOP problem : any disequilibrium leads to automatic adjustment of exchange rates.

– – – Automatic market mechanism of the demand / supply market for foreign exchange. Liquidity in the system is unnecessary, provided that adjustment occurs immediatly International money is not explicitly specified; a few currencies will be widely used as international means of payment.

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Automatic Mechanisms •

Fully fixed commodity standards

– – – – – – Fiduciary money is backed by a particular commodity (ex. Gold) The ratio of fiduciary money to the reserves of the commodity is fixed, and the monetary authorities garantee free convertibility.

All countries set a fixed price between their national currency and the commodity All currencies are tied together -> exchange rates are fixed.

The international money is the commodity.

BOP disequilibira are eliminated by transfering the commodity from the deficit country to the surplus country, leading to :    a contraction of the money supply in deficit country an expansion of the money supply in the surplus country leading to symmetrical adjustments |

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The international financial system • • •

In theory : imbalance of BOP does not depend of FX rate In practice :

– – – prices and wages are sticky (no downward flexibility of prices) some regional shocks can create asymmetric disequilibrium large players like government and financial institutions influence equilibrium

Problem of adjustments : central concern of government

Need for design of institutions |

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Exchange rate determination

Parity Conditions

1. Inflation rate differential 2. Interest rate differential 3. Forward exchange rate 4. Interest rate parity

Assets Models

1. Interest rate differential 2. Economic Growth prespectives 3. Demand and Supply of Assets 4. Economic Stability 5. Speculation and market liquidity 6. Political risk

Spot Exchange Rate

Balance of Paiements Approach

1. Current account 2. Direct & portfolio investment flows 3. Exchange rate regimes 4. Level of currency reserves |

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Exchange rate determination

Approaches for exchange rate determination :

1. Parity Conditions

Purchasing Power Parity Interest Rate Parity Fisher Effect Forward market

2. Balance of payments approaches

FX such that BOP in equilibrium Adjustment mechanisms

3. Asset Models

Foreign direct investment Country risk Alternative opportunities Growth prospects Others : news, bubbles, overshooting...

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1. Parity Conditions • •

Five key theoretical economic relationships results from arbitrage activities.

Arbitrage regards exchange rates, interest rates, inflation rates, and the link between domestic and international financial markets :

– – – – – Purchasing Power Parity (PPP) Fisher Effect (FE) International Fisher Effect (IFE) Interest Rate Parity (IRP) Forward rates as unbiased predictors of future spot rates (UFR) |

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1. Parity Conditions • Relationships among Spot Rates, Forward Rates, Inflation Rates, and Interest Rates (Shapiro, p 118) : UFR Expected percentage change of spot rate of foreign currency - 3% IFE PPP Forward discount or premium on foreign currency - 3% IRP Interest rate differential +3% FE Expected inflation rate differential +3% Common denominator of these parity conditions: adjustment of the various rates and prices to inflation (csq of a money supply in excess of real output growth - monetary theory) |

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1.1. Purchasing Power Parity

Parity Relations - PPP

•

Absolute Purchasing Power Parity - Definition

– – – – – – P = S.P* : “law of one price” Domestic Prices (P) = Exchange Rate (S).Foreign Prices (P*) P and P* = general price indices Rearranging : S = P/P* The spot exchange rate between 2 currencies is equal to the ratio of general price levels between the 2 countries.

Originally from : Swedish Economist Gustav Cassel in 1918.

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1.1. Purchasing Power Parity - absolute • Absolute Purchasing Power Parity - Hypotheses – Hypotheses  No transports costs  Perfect information (on prices in both countries)  Homogeneous goods  No trade barriers -> Equality brought by arbitrage – Definition of arbitrage : buy and resell without risk but with a profit  Example of arbitrage : buy 20 kg of gold in Belgium at 50.000 euros, and resell is immediately in France at 53.000 euros. Question : is this imaginable for any goods?

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PPP Illustration Big Mac Index Jan 2004 Dec 2004

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1.1. Purchasing Power Parity - Relative •

Relative

Purchasing Power Parity - Definition

– – – – – S = b.P/P* Prices across countries might differ by a constant factor “b”, accounting for transport costs and information costs.

Focuses on the movements in the exchange rate and the extent to which they reflect differential inflation.

Approximated by : dS/S = dP/P - dP*/P* : the exchange rate will adjust to reflect changes in the price levels of the two countries.

Relative PPP says that currencies with high rates of inflation should devalue relative to currencies with lower rates of inflation.

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1.1. PPP absolute & relative •

Interpretation

– No precision of causality : does the prices determine the FX rate, or the reverse?

– – Goods included : traded & non traded? If yes, hypothesis of perfect substitutability and similar productivity levels.

If only traded goods included : PPP close to a tautology – Short-run or long-run anchor? -> alternative : “cost parity theory”  (more seducing, but same nature of problems) |

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1.1. PPP absolute & relative •

Theoretial criticisms (6)

– – Information costs, transport costs, trade barriers : exist, and could change over time.

The direction of causality is unclear -> exchange rates could determine prices.

– All disturbances are monetary, or more important than real ones -> no account of productivity changes in one country.

– – – No account of productivity differential between traded & non traded goods sectors.

Ignores the role of income in determining exchange rates, and its consequences on a change in demand.

No role of capital flows. Sole focus on exchange of goods.

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1.1. PPP in practice • • Real exchange rate : nominal exchange rate adjusted for changes in the relative purchasing power of each currency since some base period : – – S’ t = S t . (1+i*) t / (1+i) t where i=domestic expected inflation rate; i*= foreign expected inflation rate

Empirical evidence of PPP

– – – General consensus : holds up well in the long run, nut not over short time periods.

Empirical support for the existence of mean-revering behavior of exchange rates.

See graphs in Shapiro |

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1.2. Fisher Effect (FE) •

Definition

– – – – – – The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus a compensation for expected inflation.

That is : (1+ nominal interest rate) = (1+ real rate) (1+ exp. inflation) Or, in approximation : r = a + i ; r* = a* + i * Empirical tests show that the Fisher effect generally exists for short maturity government securities, but are inconclusive for longer maturities.

The generalised version of the Fisher effect asserts that real returns are equalised across countries through arbitrage, that is : a = a* Significant real interest rates differential can only subsist in case of capital markets segmentation (see part 2 of the course) |

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1.3. International Fisher Effect (IFE) •

Definition

– – The International Fisher Effect (or Fisher-open) states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries.

That is : S S t 0  ( (1 1   r r) *)

t t

– Or, in a simplified form over a single period: S t  1 S t  S t  r  r * |

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1.3. International Fisher Effect (IFE) •

Interpretation

– – – – Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates. Combination of PPP and FE.

Arbitrage between financial markets should ensure that interest rate differential between any two countries is an unbiased predictor of the future change in the spot rate of exchange (but not necessarily an accurate predictor).

Implicit assumption : foreign and domestic assets are perfect substitutes.

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1.3. International Fisher Effect (IFE) •

Empirical evidence

– – – – – Empirical tests lend some support to the international Fisher effect, despite large short-run deviations.

Holds also in the short run for nations with very rapid rates of inflation.

Some criticism comes from studies suggesting the existence of a foreign exchange risk premium for most major currencies.

Deviations can come from the reasons of changes in nominal interest rates : either in real component, or due to changes in expected inflation.

Also, speculation creates distortions in currency markets.

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1.4. Interest Rate Parity Theory (IRP) •

Covered Interest Rate Parity –

–

Definition

IRP states that returns between assets in different countries should be equalised . If they are not, equalisation is brought by arbitrage.

– – It gives :  (1+r t *) . F t = (1+r t ).S

t  Return of foreign investment = return of domestic investment where :  r t * = foreign interest rate ;  r t = domestic interest rate  F t = forward exchange rate  S t = spot exchange rate |

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1.4. Interest Rate Parity Theory (IRP) •

Interpretation

– The movement of funds between two currencies to take advantage of the interest rate differentials is a major determinant of the spread between forward and spot rates.

– The forward discount or premium is closely related to the interest rate differential between both currencies.

– – If : F t = S.(1+r t )/(1+r t *) , the fwd discount or premium covers the interest rate differential, and the fwd rate is said to be at interest

rate parity.

No possibilities of arbitrage left then on the money market (see further the currency risk hedging) |

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1.4. Interest Rate Parity Theory (IRP) •

The Forward Rate

– A

forward rate

some future date is an exchange rate quoted today for settlement at – – The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold

forward

at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) The

forward premium

or between the spot and forward rates stated in annual percentage terms :

discount

is the percentage difference Fwd premium or discount = (Fwd - Spot)/Spot * 360/n days of fwd contract |

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1.4. Interest Rate Parity Theory (IRP) • Hypotheses – – – – Assets : same risk, same maturity No transaction costs No information costs No control on capital flows  Plus, the transaction in the forward market implies that there is no foreign exchange risk (risk that S changes while investing abroad).

 Arbitrage : Ex. return greater abroad, we have : – (1+r t *) . F t /S t > (1+r t ) -> Investors will sell spot rate and buy forward (to invest abroad), causing S to rise and F to fall, getting back to equality.

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1.5. Forward Market for foreign exchange •

Speculation

– Next to arbitrageurs, another important group on the forex markets: speculators. – – – They deliberately expose themselves to exchange rate risk.

Speculators will trade on the basis of the difference between f (forward) and s e (spot expected) at a given time horizon. Trade until f = s e |

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1.5. Forward Market for foreign exchange •

Speculation - Example

– If f > s s e e , speculators will buy large amounts of fwd contracts, to sell spot at the end of the period, with an expected profit = (f ) x n contracts.

– Example : f USD 3 mths= 1.37 $/€ ; s e USD 3 months= 1.30 $/€ => buy large amount of $ against € at 3 months. In 3 months : buy the $ fwd at 1.37 (0.73€) and resell them on the spot market at 1.30 (0.77€). Profit = 0.04€ per $.

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1.5. Forward Market for foreign exchange • •

Leads to the

–

f = s

e

unbiased nature of the forward rate

(UFR) Hypotheses underlying this relation:

– – – Speculators are risk neutral Not prevented from operating on the forward market No transaction costs |

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1.5. Forward Market for foreign exchange • – – – – – –

Unbiased estimator

With raional expectations hypothesis we have : s t = s t e + u t , u t being a random walk (µ=0) with the arbitrage relation : s e = f we have : s t meaning : f t-1 = f t-1 + u t (1) = non biaised estimator of S t (1) is the efficient market condition relating the actual spot exchange rate to the forward rate.

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1.5. Forward Market for foreign exchange •

Econometrical testing over market efficiency of fwd rates:

– Difficulty : joint test, both on market efficiency and on fundamentals of the model supposed to derive s e – Methods using regressions and serial autocorrelation tests •

Some results of the econometrical tests :

– Empirical support of existence of a risk premium (time-varying), but no clear model of formation.

– The lagged spot rate (s t-1 ) outperforms the forward rate at predicting the spot rate -> abnormal profits could have been made, trading on the basis of the difference between the current spot rate and the forward rate at a given time.

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1.5. Forward Market for foreign exchange •

Survey data about expectations formation of agents :

– Expected change in spot rates is not an unbiased predictor of actual change in the spot rate.

– Agents bias their estimation of spot rates, based on extrapolation of recent trend -> destabilising expectations on exchange rates.

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1.6. Summary of Section 1 •

Some results :

– Serious theoretical questions on PPP theory and few empirical support.

– IRP theory includes the role of capital mobility and arbitrage. – Relationship between spot and forward rates suggest the existence of a time-varying risk premium and some irrationality of market participants while forming expectations of exchange rates. – The existence of a risk premium states that assets domestic and abroad are not perfect substitutes, and that interest rates in any country may not be identical to those abroad, even with no particular expectations of spot rate changes.

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2. Balance of Payments • •

General idea : FX rates are adjusted so that the BOP is in equilibrium Definition :

– – – – – Balance of paiements : sum of all the transactions between the residents of a country and the rest of the world BOP = current account balance + capital account + financial account + changes in reserves

BOP = (X - M) + (CI - CO) + (FI - FO) + FXB

Current account = exports - imports of goods & services Capital account = capital inflows - capital outflows = capital transfers related to purchase and sale of fixed assets.

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2. Balance of Payments • • Balance of Payments (BOP) – –

Definition

: Financial account = financial inflows - financial outflows = net foreign direct investments + net portfolio investments Current + Capital + Financial accounts =

Basic balance

– FXB : changes in official monetary reserves (gold, foreign currencies, IMF position) Current account balance (X-M) – In equilibrium : X-M = 0 – Deficit country : X-M < 0 – Surplus country : X-M > 0 |

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BoP - Examples

Exhibit 5.2 Examples of Entries in the U. S. Balance-of-Payments Accounts

Credits Current Account

Sales of wheat to Great Britain; Sales of computers to Germany ; Sales of Phantom jets to Canada Licensing fees earned by Lotus 1-2-3; Spending by Japanese tourists at Disneyland ; Interest earnings on loans to Argentina; Profits on U. S. owned Auto plants abroad

Debits Current Account

Purchases of oil from Saudi Arabia; Purchases of Japanese automobiles ; Payments to German workers at U. S.

bases in Germany ; Hotel bills of U. S. tourists in Paris ; Profits on sales by Nestlé’s U. S. affiliate ; Remittances by Mexican Americans to relatives in Mexico; Social Security payments to Americans living in Italy; Economic aid to Pakistan.

Source : Multinational Financial Management by Shapiro, Alan C.(Author) Somerset, NJ, USA: John Wiley , 2002. Page 192.

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BoP - Examples

Capital Account

Purchases by the Japanese of U. S. real estate; Increases in Arab bank deposits in New York banks; Purchases of U. S. Treasury bonds by Bank of Japan; Increases in holdings of New York bank deposits by Saudi Arabian government

Capital Account

New investment in a German chemical plant by Du Pont; increases in U. S. bank loans to Mexico; deposits in Swiss banks by Americans; purchases of Japanese stocks and bonds by Americans Deposits of funds by the U. S. Treasury in British banks; Purchases of Swiss-franc bonds by the Federal Reserve

Official Reserve Account Official Reserve Account

Purchases of gold by the U. S. Treasury; Increases in holdings of Japanese yen by the Federal Reserve Source : Multinational Financial Management by Shapiro, Alan C.(Author) Somerset, NJ, USA: John Wiley , 2002. Page 192.

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2. Balance of Payments - Adjustement Domestic price of foreign exchange S eq Deficit M > X Supply of foreign exchange (due to X) = D of domestic curr.

X M Demand for foreign exchange(due to M) = S of domestic curr.

Q of foreign exchange |

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2. Balance of Payments - Adjustment •

Deficit country (current account deficit)

– X - M < 0 : too many imports compared to exports – – Money supply > money demand (in domestic currency) Too large amount of domestic currency : deflationary pressures •

Surplus country (current account surplus)

– – – X - M > 0 : too many exports compared to imports Money demand > money supply (in domestic currency) Lack of domestic currency : inflationary pressures |

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2. Balance of Payments - Adjustment Domestic price of foreign exchange Supply of foreign exchange Depreciation S 0 S 1 Demand for foreign exchange Q of foreign exchange • S = FX rate = P/P* = amount of domestic currency per one unit of foreign currency. Ex. €/$ = S for Europeans. A

depreciation

of the domestic currency = a

rise

in S. • Ex. S 0 = 1, S 1  S 1 = 0.9 : : excess of demand= deficit of BOP (too many imports).  A depreciation makes foreign goods more expensive, and D decreases to equilibirum.

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2. Balance of Payments - Adjustment • In case of floating exchange rates : – Deficit countries : FX rates are expected to depreciate, due to the excess supply of money.

– Surplus countries : FX rates are expected to appreciate, due to the relative shortage of domestic currency.

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2. Balance of Payments - Adjustment • In case of fixed exchange rates : – – – Government in charge of the BOP equilibrium FX rates maintained via the change in currency reserves – In case of deficit : the central bank ease devaluation pressure by buying the domestic currency and selling foreign currencies (out of its reserves) and gold. If the imbalance is too large and the central banks run out of reserves, the domestic currency will devalue. BOP imbalances are then used to forecast the evolution of FX rates. Ex. : the Thai Baht.

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2. Balance of Payments - Adjustment • In case of managed floats : – – Changes on relative interest rates to influence the capital inflows or outflows impacting the BOP and the valuation of a currency. Ex : rise in interest rates to increase money demand (capital inflows) and support the value of the currency. BOP trends helps forecasting such moves.

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2. BoP - FX Policy Implications •

Possible policies for a

deficit

country :

– – – let the FX rate depreciate and restore competitiveness, leading to a rise in X and a reduction in M (if FX rates are floating) reduce the stock of money by direct intervention : buy domestic currencies against foreign currencies held in monetary reserves (if FX rates are fixed) increase interest rates to attract capital inflows (financing the deficit) and to reduce demand for imports (monetary view) |

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2. BoP - FX Policy Implications • Possible policies for a – – – –

surplus

country : let the FX rate appreciate and decrease competitiveness, leading to a reduction in X, and an increase of M increase the supply of money by direct intervention : sell domestic currencies and buy foreign currencies, growing the monetary reserves, to avoid FX appreciation increase the supply of money currencies. and sterilise to avoid a price rise : exchange M1 and M3 : sell government bonds against domestic lower interest rates to discourage capital inflows (increase outflows) and to reduce financial surplus |

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2. BoP - FX Policy Implications • Difference in the available policies of countries in deficit and in surplus

in case of fixed exchange rates

: – – A country in deficit is forced to adjust (otherwise he runs out of reserves) A country in surplus is

not

forced to adjust : can build up reserves and sterilise to avoid an increase in prices – – Called the “asymmetry” between deficit and surplus countries Will lead be the cause of one of the biggest benefit of the European Monetary Union … |

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3. Assets Models - Equilibrium •

Setting the equilibrium Spot Exchange Rate

– – In freely floating exchange rates, the equilibrium spot rate is the market clearing price, that is, the FX rate that equates supply and demand of one currency against another. Factors affecting supply and demand of two currencies:  Relative inflation rates  Relative interest rates  Relative Economic Growth rates  Political and Economic risk  to read : Shapiro, chapter 2.1.

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3. Assets Models - Expectations •

Expectations and the Asset Market Model of Exchange Rates

– – – – Role of expectations due to the fact that currencies are financial assets, and an FX rate is simply the relative price of two financial assets.

Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets.

The asset market model of exchange rate determination states that “ the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

” Consequently, shifts in preferences can lead to massive shifts in currency values (cfr. financial crises).

 to read : Shapiro, chapter 2.2.

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• 3. Assets Models - Expectations

Factors affecting expectations on currency values

– – – The nature of Money  2 roles : store of value and store of liquidity : (1) depends primarily on the country’s future monetary policy; (2) depends mostly on economic prospects and political and economical stability.

Central Bank reputation  Money can be viewed as a brand-name product whose value is backed by the reputation of the central bank that issues it.

 Underliying these reputation is trust in the willingness of the central bank to maintain price stability.

Price stability and Central Bank independence  Central Banks under political pressure might be pushed to “monetize the deficit”, that, to print money to finance it, leading to higher inflation and devalued currency.

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3.bis Other approaches • None of the models developped so far succeed to explain FX rates levels and volatility • No pattern found in FX behavior • Volatility of FX rates much higher than the fundamentals -> several models tend to explain the excessive volatility: – Dornbush overshooting model – – – – – – Portfolio approach News Bubbles Heterogenous expectations Chaos theory etc.

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3.bis “News” approach •

Testing models -

News

approach

– Try to distinguish between expected / unexpected components of exchange rates determinants – – Models sensitive to the way news are constructed, and to the choice of the type of news Poor empirical performance -> research question : what type of news is important to influence expectations on exchange rates?

Empirical findings : large role of mimetism in dealing rooms (SBS final dissertation, 2004) |

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3.4. Misalignments / Speculation • • Misalignment equilibrium : departure of exchange rate from its long-run Heterogeneous expectations models are an attempt to explain misalignments of FX rates : – – – – Wide dispersion of opinions observed, in particular for longer maturities Model of two groups of forecasters (Frankel & Froot, 1987):  Chartists : extrapolate past experience  Fundamentalists : using Dornbush’s overshooting model Portfolio managers use a weighted average of these two forecasts, and update the weights according to who is doing better.

Broad empirical support : explained the rise and fall of the dollar in early 1980’s. Questionnaires among forecasters supported the approach.

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4. Currency forecasting •

Requirements

– Given the efficiency and unpredictability of the FX markets, currency forecasting can lead to persistent profit only of the forecaster meets at least one of the following criteria :  Exclusive use of a superior forecasting model  Consistent access to information before other investors  Exploitation of small, temporary deviations from equilibrium  Ability to predict the nature of government intervention in the foreign exchange market |

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4. Currency forecasting • •

Types of forecasts

– Market-based forecasts –  Forward rates : f = s e  Interest rates : for predictions beyond one year, or for currencies with no forward markets Model-based forecasts  Fundamental analysis : examination of the macroeconomic variables and policies likely to influence a currency’s prospects. Simplest form : PPP.

 Technical analysis : exlusive focus on past price and volume movements; charting and trend analysis.

Model evaluation

– Two criteria : accuracy and correctness. And trade-off with simplicity and cost.

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