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Prof. Dr.

Streitferdt

International Business 5: International Financial Management

Winter semester 2011/12

2. Foundations of international financial management

1. 2. 3. 4. 5. 6. 7.

Prologue
Foundations of international financial management Foreign exchange markets Foreign exchange exposure management Financial management of multinational corporations Corporate Governance Mergers & Acquisitions Risikomanagement

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2. Foundations of international financial management

2. Foundations of International Financial Management

Literature

Eun, C.S. and B.G. Resnick (2007): International Financial Management, 4th international edition, McGrawHill.
Hull, J.C. (2009): Options, Futures and Other Derivatives, 7th edition, Prentice Hall.

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2. Foundations of international financial management

2. Foundations of International Financial Management

What is International Financial Management?


Four major dimensions set international finance apart from pure domestic finance:

Foreign exchange rates Market imperfections and segmentation International political risk Culture

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2. Foundations of international financial management

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Foundations of international financial management 2.1 Exchange rate system 2.2 Market imperfections and segmentation 2.3 Country risk and international political risk 2.4 Culture

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2. Foundations of international financial management

2.1 Exchange rate system

History of the international monetary system International Monetary System: Institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined

System Bimetallism Classical gold standard Interwar period Bretton Woods System Flexible exchange rate regime
Prof. Dr. Streitferdt: International Financial Management

Time period Before 1875 1875-1914 1915-1944 1945-1972 Since 1973

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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Flexible exchange rate regimes

Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to prevent unwanted volatilities Gold was officially abandoned as an international reserve asset

IMF continues to provide assistance to countries with exchange rate difficulties


The IMF extended assistance and loans to member countries on the condition that those countries follow the IMFs macroeconomic policy prescriptions Exchange rates volatility increased significantly

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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Flexible exchange rate regimes

Source:Eun/Resnick (2007)

In the Plaza Agreement and the Louvre Accord, representatives of the major economies (G-5, G-7) agreed to jointly manage the dollar exchange rate. Therefore, the system is sometimes called managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct overor undervaluation of currencies.
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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Flexible exchange rate regimes What determines the exchange rate?

Currency supply

Currency demand

Foreign demand for domestic goods Foreign demand for domestic investment opportunities Cash flow from foreign investments Money supply from central bank

Demand for goods in foreign currencies Demand for investments in foreign currencies Cash flow from domestic investments Money supply from central bank

Central bank interventions


Exchange rate regime Expected exchange rates

Central bank interventions


Exchange rate regimes Expected exchange rates
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Prof. Dr. Streitferdt: International Financial Management

Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Current exchange rate regimes

Exchange arrangements with no separate legal tender The currency of another country circulates or currency unions (e.g. Ecuador, El Salvador, and Panama with US$, Euro zone with ) Currency board arrangements Explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate (e.g. Hong Kong, Estonia) Conventional fixed peg arrangement The countrys currency is pegged at a fixed rate to a major currency (or basket of currencies), where the exchange rate fluctuates within a narrow margin 1% around a central rate (e.g. Morocco, Saudi Arabia, and Ukraine) Pegged exchange rate with horizontal bands The exchange rate is maintained within margins of fluctuation around a fixed central rate that are wider than 1% (e.g. Denmark, Slovenia, and Hungary)
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Prof. Dr. Streitferdt: International Financial Management

Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Current exchange rate regimes

Crawling pegs The exchange rate is adjusted periodically in small amounts at a fixed preannounced rate or in response to changes in selective quantitative indicators (e.g. Bolivia, Costa Rica and Tunisia) Exchange rates within crawling bands The exchange rate is maintained within certain fluctuation margins around a central rate that is adjusted periodically (e.g Belarus, Romania) Managed floating with no preannounced path for the exchange rate Active intervention of the monetary authority without specified target rates (e.g. Algeria, China, Czech Republic, India, Russia, Singapore and Thailand) Independent floating Market determined exchange rate. Interventions only aim at moderating the rate of change and preventing undue fluctuations in the exchange rate. (e.g. Australia, Brazil, Canada, Korea, Mesiko, U.K., Japan, Switzerland, US)
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Prof. Dr. Streitferdt: International Financial Management

Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Current exchange rate regimes

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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Current exchange rate regimes

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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Current exchange rate regimes

Source: Eung/Resnick (2007)

Why do countries peg their currency at a certain level? What do politicians prefer? A high or a low exchange rate?
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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Trade balance surplus and deficit and what they mean Politicians like a trade balance surplus because this means: - The country exports more than it imports. It earns more from international trade than it spends - The countrys citizens are international investors. They are net investors on the international capital market On the other side, a trade balance deficit means: - The country imports more than it exports. The citizens spend more money for foreign goods than they earn from foreign trade - If you spent more money than you earn, you have to borrow money to finance the trade balance deficit. The countrys citizens are net borrowers on the international capital market

- In the long run, there might exist the problem that nobody wants to finance your deficit anymore
Politicians prefer a trade balance surplus!
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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Exchange rates and the trade balance Assume, the exchange rate of the Euro is low. This means one US$ costs a lot of and a costs few US$. This implies

German goods cost few US$

American goods cost a lot of

Americans buy German products

Germans dont buy American products

Exports increase

Imports decrease

Trade balance surplus!

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Bimetallism

2. Foundations of international financial management

Classical gold standard Interwar period Bretton Woods System

2.1 Exchange rate system

Flexible exchange rate regime

Exchange rates, the trade balance and public debt

Politicians like low exchange rates for the domestic currency. But this is of course bad for the other country! (beggar-thy-neighbor)

On the other side: If the country is indebted in foreign currencies, a low exchange rate is a problem (Why?)

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2. Foundations of international financial management

2.1 Exchange rate system

Summary of the chapter

Todays exchange rate system is the result of a development from different exchange rate systems that didnt work out right Today we have floating exchange rates, but some Governments opt to control the exchange rate system via different tools like currency boards, pegs or managed floating systems Theoretically, politicians prefer a low exchange rate of their home currency, because this implies good prospects for exporting goods and increasing wealth, while imports diminish On the other side, a low exchange rate means high debt burdens, if the governmental debt is raised in foreign currencies

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2. Foundations of international financial management

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Foundations of international financial management 2.1 Exchange rate systems 2.2 Market imperfections and segmentation 2.3 International political risk 2.4 Culture

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2. Foundations of international financial management

2.2 Market imperfections and segmentation

A perfect global market On a perfect global market, each market participant has the same information and you have unrestricted flows of goods and capital. Moreover, all contracts would foresee all contingencies and regulate them in an appropriate way

In real life, the global market is far away from being perfect. We observe

Political restrictions Psychological restrictions Physical restrictions

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2. Foundations of international financial management

2.2 Market imperfections and segmentation

Political restrictions

Licenses, allowances and jobs are given on a non-competitive basis: Ideology, bribes, friendships etc. Some products are not freely tradable: Think of atomic weapons

Tolls and subsidies: Some products especially exports are subsidized and others get more expensive due to tolls raised (toll wars possible)
Withholding taxes: Whenever dividends and interests are paid, a tax is raised on that capital income that would not apply for domestic investors

Interventions on the currency market: Exchange rates are influenced by central bank interventions
Control of capital flows: In some countries, capital imports and exports are controlled by the government Control of work force movements: Some people are not allowed to leave their country or to work in a country (asylum seeker etc.) Missing protection of foreign investors: Foreign investors might be expropriated by local investors or mistreated by local judges
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Prof. Dr. Streitferdt: International Financial Management

2. Foundations of international financial management

2.2 Market imperfections and segmentation

Psychological restrictions

Availability bias: People tend to think that they are well informed, if there is a lot of information easily available, even though the information might be irrelevant. They prefer to invest into domestic markets because they have a lot of information available Firm visibility: Closely related to availability is visibility. If a company is visible for investors, they are more willing to invest into that company, giving domestic companies an advantage, even though they might not be better Insecurity and exchange rates: Exchange rates are an additional risky variable influencing the investment return. This gives a feeling of insecurity that people try to avoid by cancelling foreign investment, ignoring that exchange rate risk could be actively managed Cultural factors: It is widely observed that people tend to invest into country with a comparable culture. Common religion and a similar genetic background increase capital flows between the two countries. Also, comparable culture can end up in comparable tastes and the same kind of products are demanded All these reasons lead to a so called Home Bias of investors

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2. Foundations of international financial management

2.2 Market imperfections and segmentation

Physical restrictions

Transaction costs: Buying and selling currencies is costly, because this is done at different rates (bid-ask-spread) Transportation costs: Transportation of some goods can be very costly (e.g. gas, perishable food) Capacity constraints: Limited transportation capacities (ships, grids etc.) prevent complete trade of some goods to satisfy the global demand Limited information processing capabilities: The human brain is not able to process all information available. Wrong trades can happen Asymmetric information: Local investors and analysts might have better information about investment opportunities in their country. Or at least this is feared by foreign investors

Incomplete contracts: It is not possible to write a complete contract that foresees and manages every single possible contingency. People might refrain from international trade because there are sometimes no accepted rules about what happens in an unforeseen contingency (which court decides this?)
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Prof. Dr. Streitferdt: International Financial Management

2. Foundations of international financial management

2.2 Market imperfections and segmentation

Market segmentation and international financial management

If we only had one global market for goods and capital, international financial management would be the same as domestic management.

But the global market is segmented due to the restrictions mentioned.


Domestic financial management is different from international financial management, because we talk about two different markets International financial management must be aware of the restrictions mentioned and often tries to mitigate their consequences (e.g. tax evasion) International financial management takes place in a larger market than domestic financial management and deals with investment and financing strategies in different financial markets

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2. Foundations of international financial management

2.2 Market imperfections and segmentation

Summary of the chapter

Market imperfections stem from political, psychological and physical restrictions Governments can choose to control international trade and capital flows and therefore segment their markets from the international market

Psychological restrictions stem from limited information processing capabilities and general human behavior that lead to non rational acting and segment the markets
Physical restrictions limit the trading of goods due to costs of transportation, dealing, information and capacities

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2. Foundations of international financial management

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Foundations of international financial management 2.1 Exchange rate systems 2.2 Market imperfections and segmentation 2.3 International political risk 2.4 Culture

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2. Foundations of international financial management

2.3 International political risk

International political risk Foreign investors face political risk of changing laws in the countries they produce and distribute.

Types of international political risk

Transfer risk

Capital flow controls, withholding taxes


Policies via local operations Expropriation/Nationalization

Operational risk
Control risk

International political risk might as well be mitigated by international financial management due to

Diversification of country risk Higher hurdles for governments to impose negative actions
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Prof. Dr. Streitferdt: International Financial Management

2. Foundations of international financial management

2.3 International political risk

Evaluating political risk Factors for evaluating political risk

The host countrys political and government system Track records of political parties and their relative strength Integration into the world system The host countys ethnic and religious stability

Regional security
Key economic indicators

Available assessment on country risk (political risk + credit risk) Rating agencies Morgan Stanley Euromoney
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Prof. Dr. Streitferdt: International Financial Management

2. Foundations of international financial management

2.3 International political risk

What foreign investors usually search for

Stable political conditions No general social conflict Stable economic prospects Predictable behavior of administration and civil servants National reputation of sticking to contracts An independent and fair jurisdiction A consistent set of laws A good relationship between the country and the home country of the foreign investors

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2. Foundations of international financial management

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Foundations of international financial management 2.1 Exchange rate systems 2.2 Market imperfections and segmentation 2.3 International political risk 2.4 Culture

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2. Foundations of international financial management

2.4 Culture

-Hall -Hofstede

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2. Foundations of international financial management

2.4 Culture

Dimensions and types of culture: Hall

High context culture


Context orientation Low context culture Privacy sphere Space orientation

Territory
Monochronic orientation

Time orientation

Polychronic orientation High

Speed of information

Low

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2. Foundations of international financial management

2.4 Culture

Dimensions and types of culture: Hofstede

Large vs. small power distance Individualism vs. collectivism

Masculinity vs. femininity


Strong vs. weak uncertainty avoidance Short vs. long time perspective

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