Introduction to International

Financial Management
Lecture # 2
What is International Finance?
• International finance is the branch of economics that studies the
dynamics of exchange rates, foreign investment, global financial
system, and how these affect international trade. It also studies
international projects, international investments and capital flows,
and trade deficits. It includes the study of futures, options and
currency swaps. International finance is a branch of international
economics
From: Wikipedia
Benefits of studying International Finance
• Among the events that affect the firm and that must be managed are changes in
exchange rates, inflation rates, and asset values (and these events are often themselves
related).
• Because of the integration of financial markets, events in distant lands have effects that
reverberate in other regions of the world (domino effects, contagion, systemic risk).
• Even companies with a domestic focus are affected by the global financial environment
as they compete with firms that are internationally active.
• Inflation, jobs, economic growth rates, bonds and stock prices, oil and food prices,
government revenues and other important financial variables are all tied to exchange
rates and other developments in the increasingly integrated financial market.
• For students in economics or business administration understanding IF is of fundamental
importance.
Growing importance of International Finance
• Over the last decades international financial flows have grown much faster
than world GDP or world trade.
• This trend is in large parte a reflection of international trade and the process
of globalization.
• However, international financial flows have grown much faster than the real
economy.
• Between 2002 and 2007 (before the start of the crisis international) financial
flows have grown from 5% to 17% of world GDP
• While IF contributes to world prosperity through the efficient allocation of
capital worldwide, it is also a source of concern for the challenges that it
poses for financial stability as shown by the recent financial crises
Factors behind the growth of IF
• Growth of International Trade (finance associated to commercial
trade)
• Growth of Multinational Corporations (finance associated to FDIs and
M&A activity) and Multinational Banking
• Growth of the Eurodollar market
• Growth of International Finance itself (finance associated to the
growth of global saving and the need to improve risk-return trade-
offs)
A world of currencies
• When dealing with IF one has to face the problems of having different currencies and how to exchange
one for another (through exchange rates).
• The number of national currencies remains very high notwithstanding 17 national currencies have
disappeared with the introduction of the euro.
• Not only money and bank deposits but also financial assets are denominated in a national currency.
• Reserve currencies are those mostly used in international transactions (US $, Euro, yen, once the British
pound).
• The US $ is still used to price oil.
• Central banks normally hold relevant quantities of reserve currencies to use in the money and exchange
markets for their operations in addition to gold.
• The IMF Special Drawing Rights (SDR) is an international currency albeit it is not physical but only serves
as an accounting unit.
• The US $ still accounts for 60% of all international reserves (Table on distribution of international
reserves)
Gold
• Gold still represents an important share of international reserves (see
IMF statistics).
• Most of gold is held by central banks and the IMF but private
institutions like investment funds also have gold in their asset portfolios.
• The US and most European countries hold more than 70% of their
foreign reserves in gold bars.
• Why is gold so important?
• Gold still represents an important store of value. Albeit its price changes
daily on a market basis, its value does not depend on ‘trust’ like in the
case of currencies.
Introduction
• Exchange rates, foreign currency, international finance – they are
unavoidable in the global economy however much people may wish it
otherwise
• The increased importance being attached to exchange rates is a result
of the globalization of modern business
• The continuing growth in world trade relative to national economies
• The trend towards economic integration
• And the rapid pace of change in the technology of money transfer
What is an exchange rate?
• The first thing to understand about the exchange rate is that it is
simply a price
• Suppose that it is quoted on a book £50, which means a book sells for £50, or
can be bought at that price
• It changes hands at an exchange rate of 1 book = £50.
• From the bookseller’s point of view, the price of £1 is 1/50th of a copy of that
book
• If its price changed to £51, the shop would need to supply only 1/51st of a
copy in order to earn £1.
• So a rise in the price of the book, from £50 to £51, is the same as a fall in the
price of money, from 1/50th to 1/51st of a book
Foreign Exchange Market
• Foreign Exchange market:
Market where different currencies are traded, one for another.
• The exchange rate enables people in one country to translate the
prices of foreign goods into units of their own currency.
• An appreciation of a nation’s currency will make foreign goods
cheaper.
• A depreciation of a nation’s currency will make foreign goods
more expensive.
Foreign Exchange Market Equilibrium
• The dollar price of the English pound
is measured on the vertical axis. The Dollar price of
foreign exchange
horizontal axis indicates the flow of (for pounds)
S(sales to
pounds in exchange for dollars.
foreigners)
• The demand and supply of pounds are
in equilibrium at the exchange rate of
$1.50 = 1 English pound. Excess supply
of pounds
• At this price, quantity demanded $1.80
equals quantity supplied.
• A higher price of pounds (like $1.80 $1.50 c
= 1 pound), leads to an excess supply Excess demand
for pounds
of pounds ... causing the dollar price $1.20
of the pound to fall (depreciate). D(purchases from
• A lower price of pounds (like $1.20 foreigners)
= 1 pound), leads to an excess demand Quantity of
foreign exchange
for pounds … causing the dollar price Q (pounds)

of pounds to rise (appreciate).

Changes in the Exchange Rate
• Factors that cause a currency to depreciate:
• a rapid growth of income (relative to trading partners)
that stimulates imports relative to exports
• a higher rate of inflation than one's trading partners
• a reduction in domestic real interest rates (relative to
rates abroad)
• a reduction in the attractiveness of the domestic
investment environment that leads to an outflow of
capital
Changes in the Exchange Rate
• Factors that cause a currency to appreciate:
• a slower growth rate relative to one’s trading partners
• a lower inflation rate than one's trading partners
• an increase in domestic real interest rates
(relative to rates abroad)
• an improvement in the attractiveness of the domestic
investment environment that leads to an inflow of
capital