Chapter 17 International Finance

Chapter 17

• International Finance

INTERNATIONAL FINANCE

• In the last thirty years business has become

• increasingly international - global

• Volume of both imports and exports has increased

• U.S. is now a net importer

• The nature of international business has changed

• Import - Export has shifted to Multi-National Companies (MNCs)

• Run complete companies in other countries

• Direct Investment in facilities and equipment

• Portfolio Investments in foreign stocks and bonds

• are common

• TM 17-1

EXCHANGE RATES AFFECT PRICES AND QUANTITIES

• They change the domestic price paid for foreign goods

• They therefore impact:

• 1. The general cost of living

• 2. Domestic employment

• CHANGING EXCHANGE RATES AND EXCHANGE RATE RISK

• A firm can make or lose money on an international transaction due to rate movements outside of the business deal itself

• SPOT AND FORWARD RATES

• The Terminology of Exchange Rate Movements

• A currency gets stronger or rises when it becomes more valuable

• in terms of dollars

• The converse is to get weaker or fall against the dollar.

• Hedging With Forward Exchange Rates

• Forward contracts lock in exchange rates in advance removing

• exchange rate risk from transactions

• TM 17-3

SUPPLY AND DEMAND - THE SOURCE OF EXCHANGE RATE MOVEMENT

• The Supply and Demand for Foreign Exchange

• Depends on the demand in each country for the exports of the other

• Dollars

• (per franc)

• $.25

• Supply

• Exch

• Rate

• (dir) Demand

• $.20

• Francs

• (a) Supply & Demand for Francs in Terms of Dollars ($ weaker as it moves

• up on vertical axis) - Foreign Exchange, Figure 17-2

• TM 17-4 Slide 1 of 2

• Francs

• (per dollar)

• F5.0

• Supply

• Exch

• Rate

• (indir) Demand

• F4.0

• Dollars

• (b) Supply & Demand for Dollars in Terms of Francs ($ stronger as it moves

• up on vertical axis) - Foreign Exchange, Figure 17-2

• WHY EXCHANGE RATES MOVE

• Preferences in Consumption

• Government Policy

• Economic Conditions

• Speculation

• Direct Government Intervention

• TM 17-4 Slide 2 of 2

GOVERNMENT INTERVENTION

• Exchange rates affect the domestic economy through the cost of imported goods and the employment from production for export

• Therefore the Government Has an Incentive to Influence Exchange Rates

• It does so by buying and selling its own currency

• in foreign exchange market

• TM 17-5 Slide 1 of 2

THE INTERNATIONAL MONETARY SYSTEM

• Now on a floating exchange rate system

• From WWII until early 70s on a fixed exchange rate system

• Administered by the International Monetary Fund (IMF)

• Convertibility

• Not all currencies are traded in foreign exchange markets

• Difficult to expatriate profits from direct investment

• THE BALANCE OF TRADE

• Deficit vs surplus

• Deficit induced by foreign government policy - Japan

• Negative Effects of a Deficit

• Weak dollar

• Economic control

• TM 17-5 Slide 2 of 2

INTERNATIONAL CAPITAL MARKETS

• The Unique Status of the American Dollar

• An "international currency"

• Superpower militarily and economically

• International businesses are willing to take dollars in trade

• Contracts are often denominated in dollars

• even when parties are not American

• THE EURODOLLAR MARKET

• A Eurodollar is an American dollar

• deposited in a bank outside the United States

• Banks create the Eurodollar Market by lending Eurodollars

• to international companies and foreign governments

• TM 17-6 Slide 1 of 2

THE INTERNATIONAL BOND MARKET

• International Bond

• A bond sold outside of the home country of the borrower

• Foreign Bond

• A bond denominated in the currency of the country in which it is sold,

• but issued by a foreign borrower

• Eurobond

• A bond denominated a currency other than that of the country

• in which it is sold

• Less disclosure - lower flotation costs

• Issued in bearer form - owner not identified

• No tax withheld on interest

• Attractive to investors interested in privacy and/or avoiding

• their own countries' taxes

• TM 17-6 Slide 2 of 2

POLITICAL RISK

• The probability that the value of an investment will be reduced

• by political actions

• Actions are usually by the host government, but the idea includes terrorism

• Expropriation is generally the worst case scenario

• Less drastic actions include:

• Raising taxes

• Limiting expatriated profit

• Requiring that inputs be purchased locally

• Limiting prices

• Part ownership by natives

• Political risk is small in Western Europe, Japan, Taiwan, and Australia

• It can be substantial in the former Eastern Bloc and the third

• world nations of Africa, Asia, and South America

• TM 17-7

TRANSLATION GAIN/LOSS/RISK

• Gain or loss on translating balance sheet of subsidiary

• in a foreign country

• (Direct investment)

• Not real unless the assets are actually sold

• No tax effect

• TM 17-8