INTERNATIONAL FINANCIAL MANAGEMENT

Ch 1 Globalization and the Multinational Firm

1) What’s Special about “International” Finance?

 Foreign Exchange Risk
 Political Risk
 Market Imperfections
 Expanded Opportunity Set

Foreign Exchange Risk

The risk that foreign currency profits may evaporate in dollar terms due to
unanticipated unfavorable exchange rate movements.
Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share. One
year later the investment is worth ten percent more in yen: ¥110,000 But, if
the yen has depreciated to $1 = ¥120, your investment has actually lost money
in dollar terms.
Political Risk
Sovereign governments have the right to regulate the movement of goods,
capital, and people across their borders. These laws sometimes change in
unexpected ways.
Market Imperfections
 Legal restrictions on the movement of goods, people, and money
 Transactions costs
 Shipping costs
 Tax arbitrage
Expanded Opportunity Set

It doesn’t make sense to play in only one corner of the sandbox.True for
corporations as well as individual investors.
2) Goals for International Financial Management

 The focus of the text is to equip the reader with the “intellectual toolbox” of an
effective global manager—but what goal should this effective global manager be
working toward?
 Maximization of shareholder wealth? or
 Other Goals?

Maximize Shareholder Wealth

 Long accepted as a goal in the Anglo-Saxon countries, but complications arise.
 Who are and where are the shareholders?
 In what currency should we maximize their wealth?
Other Goals
In other countries shareholders are viewed as merely one among many
“stakeholders” of the firm including:
 Employees
 Suppliers
 Customers
 In Japan, managers have typically sought to maximize the value of the keiretsu—a
family of firms to which the individual firms belongs.
Other Goals
 As shown by a series of recent corporate scandals at companies like Enron,
WorldCom, and Global Crossing, managers may pursue their own private
interests at the expense of shareholders when they are not closely monitored.

 These calamities have painfully reinforced the importance of corporate

governance i.e. the financial and legal framework for regulating the relationship
between a firm’s management and its shareholders.

 These types of issues can be much more serious in many other parts of the
world, especially emerging and transitional economies, such as Indonesia,
Korea, and Russia, where legal protection of shareholders is weak or virtually
non-existing.
  No matter what the other goals, they cannot be achieved in the long term if the
maximization of shareholder wealth is not given due consideration.

Globalization of the World Economy: Major Trends

 Emergence of Globalized Financial Markets
 Emergence of the Euro as a Global Currency
 Trade Liberalization and Economic Integration
 Privatization
Emergence of the Euro as a Global Currency
 A momentous event in the history of world financial systems.
 Currently more than 300 million Europeans in 15 countries are using the common
currency on a daily basis.
 In May 2004, 10 more countries joined the European Union and adopted the euro.
 The “transaction domain” of the euro may become larger than the U.S. dollar’s in
the near future.
Euro Area Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, Malta, the Netherlands, Portugal, Slovenia, Spain
Economic Integration
 Over the past 50 years, international trade increased about twice as fast as
world GDP.
 There has been a sea change in the attitudes of many of the world’s
governments who have abandoned mercantilist views and embraced free trade
as the surest route to prosperity for their citizenry.
Liberalization of Protectionist Legislation
 The General Agreement on Tariffs and Trade (GATT) a multilateral agreement
among member countries has reduced many barriers to trade.
 The World Trade Organization has the power to enforce the rules of
international trade.
 On January 1, 2005 the end of the era of quotas on imported textiles ended.
 This is an event of historic proportions.
NAFTA
 The North American Free Trade Agreement (NAFTA) calls for phasing out
impediments to trade between Canada, Mexico and the United States over a
15-year period beginning in 1994.
 For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in
1973 to 29% in 2006.
 The increased trade has resulted in increased numbers of jobs and a higher
standard of living for all member nations.
Privatization
 The selling off state-run enterprises to investors is also known as
“Denationalization”.
 Often seen in socialist economies in transition to market economies.
 By most estimates this increases the efficiency of the enterprise.
 Often spurs a tremendous increase in cross-border investment.
Multinational Corporations
 A firm that has incorporated on one country and has production and sales
operations in other countries.
 There are about 60,000 MNCs in the world.
 Many MNCs obtain raw materials from one nation, financial capital from
another, produce goods with labour and capital equipment in a third country
and sell their output in various other national markets.

Top 10 MNCs

1 . General Electric - United States

2 . Vodafone Group PLC - United Kingdom
3 . General Motors - United States
4 . British Petroleum Co. PLC - United Kingdom
5 .Royal Dutch/Shell Group - UK/Netherlands
6 . ExxonMobile Corporation - United States
7 . Toyota Motor Corporation - Japan
8 . Ford Motor Company - United States
9 . Total - France
10 .Eléctricité de France – France
CH-2 The International Monetary System

1 . Evolution of the International Monetary System

 Bimetallism: Before 1875
 Classical Gold Standard: 1875-1914
 Interwar Period: 1915-1944
 Bretton Woods System: 1945-1972
 The Flexible Exchange Rate Regime: 1973-Present

Bimetallism: Before 1875

 A “double standard” in the sense that both gold and silver were used as money.
 Some countries were on the gold standard, some on the silver standard, some
on both.
 Both gold and silver were used as international means of payment and the
exchange rates among currencies were determined by either their gold or silver
contents.
 Gresham’s Law implied that it would be the least valuable metal that would
tend to circulate.
Classical Gold Standard: 1875-1914
During this period in most major countries:
 Gold alone was assured of unrestricted coinage
 There was two-way convertibility between gold and national currencies at a
stable ratio.
 Gold could be freely exported or imported.
 The exchange rate between two country’s currencies would be determined by
their relative gold contents.
For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the
British pound is pegged to gold at £6 = 1 ounce of gold, it must be the case that the
exchange rate is determined by the relative gold contents:
$30 = £6
$5 = £1
  Highly stable exchange rates under the classical gold standard provided an
environment that was conducive to international trade and investment.
 Misalignment of exchange rates and international imbalances of payment were
automatically corrected by the price-specie-flow mechanism.
There are shortcomings:
 The supply of newly minted gold is so restricted that the growth of world trade
and investment can be hampered for the lack of sufficient monetary reserves.
 Even if the world returned to a gold standard, any national government could
abandon the standard.
Interwar Period: 1915-1944
 Exchange rates fluctuated as countries widely used “predatory” depreciations
of their currencies as a means of gaining advantage in the world export market.
 Attempts were made to restore the gold standard, but participants lacked the
political will to “follow the rules of the game”.
 The result for international trade and investment was profoundly detrimental.
Bretton Woods System: 1945-1972
 Named for a 1944 meeting of 44 nations at Bretton Woods, New Hampshire.
 The purpose was to design a post-war international monetary system.
 The goal was exchange rate stability without the gold standard.
 The result was the creation of the IMF and the World Bank.
 Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per
ounce and other currencies were pegged to the U.S. dollar.
 Each country was responsible for maintaining its exchange rate within ±1% of
the adopted par value by buying or selling foreign reserves as necessary.
 The Bretton Woods system was a dollar-based gold exchange standard.
The Flexible Exchange Rate Regime: 1973-Present.
Flexible exchange rates were declared acceptable to the IMF members.
 Central banks were allowed to intervene in the exchange rate markets to iron
out unwarranted volatilities.
 Gold was abandoned as an international reserve asset.
 Non-oil-exporting countries and less-developed countries were given greater
access to IMF funds.
Current Exchange Rate Arrangements
Free Float
The largest number of countries, about 48, allow market forces to determine their
currency’s value.
Managed Float
About 25 countries combine government intervention with market forces to set
exchange rates.
Pegged to another currency
Such as the U.S. dollar or euro (through franc or mark).
No national currency
Some countries do not bother printing their own, they just use the U.S. dollar. For
example, Ecuador has recently dollarized.
European Monetary System
Eleven European countries maintain exchange rates among their currencies within
narrow bands, and jointly float against outside currencies.
Objectives:
 To establish a zone of monetary stability in Europe.
 To coordinate exchange rate policies vis-à-vis non-European currencies.
 To pave the way for the European Monetary Union.
The Euro
1. What is the euro?
2. When will the new European currency become a reality?
3. What value do various national currencies have in euro?
What Is the Euro?
 The euro is the single currency of the European Monetary Union which was
adopted by 11 Member States on 1 January 1999.
 These member states are: Belgium, Germany, Spain, France, Ireland, Italy,
Luxemburg, Finland, Austria, Portugal and the Netherlands.

What is the subdivision of the euro?

  During the transitional period up to 31 December 2001, the national currencies
of the member states (Lira, Deutsche Mark, Peseta, Franc. . . ) will be "non-
decimal" subdivisions of the euro.
 The euro itself is divided into 100 cents.
What is the official sign of the euro?
 The sign for the new single currency looks like an“E” with two clearly marked,
horizontal parallel lines across it.
 It was inspired by the Greek letter epsilon, in reference to the cradle of
European civilization and to the first letter of the word 'Europe'.
What are the different denominations of the euro notes and coins ?
 There will be 7 euro notes and 8 euro coins.
 The notes will be: 500, 200, 100, 50, 20, 10, and 5 euro.
 The coins will be: 2 euro, 1 euro, 50 euro cent, 20 euro cent, 10, euro cent, 5
euro cent, 2 euro cent, and 1 euro cent.
How will the euro affect contracts denominated in national currency?
 All insurance and other legal contracts will continue in force with the
substitution of amounts denominated in national currencies with their
equivalents in euro.
 Euro values will be calculated according to the fixed conversion rates with the
national currency unit adopted on 1 January 1999.
 Generally, the conversion to the euro will take place on 1 January 2002, unless
both parties to the contract agree to do so beforehand.

The Mexican Peso Crisis

 On 20 December, 1994, the Mexican government announced a plan to devalue
the peso against the dollar by 14 percent.
 This decision changed currency trader’s expectations about the future value of
the peso.
 They stampeded for the exits.
 In their rush to get out the peso fell by as much as 40 percent.
 The Mexican Peso crisis is unique in that it represents the first serious
international financial crisis touched off by cross-border flight of portfolio
capital.
Two lessons emerge:
 It is essential to have a multinational safety net in place to safeguard the world
financial system from such crises.
 An influx of foreign capital can lead to an overvaluation in the first place.

The Asian Currency Crisis

 The Asian currency crisis turned out to be far more serious than the Mexican
peso crisis in terms of the extent of the contagion and the severity of the
resultant economic and social costs.
 Many firms with foreign currency bonds were forced into bankruptcy.
 The region experienced a deep, widespread recession.

Currency Crisis Explanations

 In theory, a currency’s value mirrors the fundamental strength of its underlying
economy, relative to other economies. In the long run.
 In the short run, currency trader’s expectations play a much more important
role.
 In today’s environment, traders and lenders, using the most modern
communications, act by fight-or-flight instincts. For example, if they expect
others are about to sell Brazilian reals for U.S. dollars, they want to “get to the
exits first”.
 Thus, fears of depreciation become self-fulfilling prophecies.
Fixed versus Flexible Exchange Rate Regimes
 Arguments in favour of flexible exchange rates:
 Easier external adjustments.
 National policy autonomy.
 Arguments against flexible exchange rates:
 Exchange rate uncertainty may hamper international trade.
 No safeguards to prevent crises.