Chapter 2 Foundations of International Financial Management

7/27/2019 Chapter 2 Foundations of International Financial Management

1/33

Prof. Dr. Streitferdt

International Business 5:

International Financial Management

Winter semester 2011/12


2/33

14

2. Foundations of international financial management

Prof. Dr. Streitferdt: International Financial Management

1.

2.

3.

4.

5.

6.

Prologue

Financial management of multinational corporations

Corporate Governance

Foreign exchange markets

Foreign exchange exposure management

7. Mergers & Acquisitions

8. Risikomanagement

Foundations of international financial management


3/33

15



2. Foundations of International Financial Management

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.

Literature


4/33

16



What is International Financial Management?

2. Foundations of International Financial Management

Foreign exchange rates

Market imperfections and segmentation

International political risk

Culture

Four major dimensions set international finance apart

from pure domestic finance:


5/33

17



2.1 Exchange rate system

2.2 Market imperfections and segmentation

2.3 Country risk and international political risk2.4 Culture



6/33

18



History of the international monetary system


International Monetary System: Institutional framework within which internationalpayments are made, movements of capital areaccommodated, and exchange rates amongcurrencies are determined

Time periodSystem

Bimetallism

Classical gold standard

Interwar period

Bretton Woods System

Flexible exchangerate regime

Before 1875

1875-1914

1915-1944

1945-1972

Since 1973


7/33 19



Flexible exchange rate regimes


Bimetallism


Interwar period


Flexible exchange rate regime

Flexible exchange rates were declared acceptable to the IMF members,and central banks were allowed to intervene in the exchange markets toprevent unwanted volatilities

Gold was officially abandoned as an international reserve asset

IMF continues to provide assistance to countries with exchange ratedifficulties

The IMF extended assistance and loans to member countries on thecondition that those countries follow the IMFs macroeconomic

policy prescriptions

Exchange rates volatility increased significantly


8/33 20





Bimetallism


Interwar period



In the Plaza Agreement and the Louvre Accord, representatives of the majoreconomies (G-5, G-7) agreed to jointly manage the dollar exchange rate.Therefore, the system is sometimes called managed-float system under whichthe G-7 countries would jointly intervene in the exchange market to correct over-

or undervaluation of currencies.

Source:Eun/Resnick (2007)


9/33 21





What determines the exchange rate?

Foreign demand for domesticgoods

Foreign demand for domesticinvestment opportunities

Cash flow from foreigninvestments

Money supply from central bank

Central bank interventions

Exchange rate regime

Expected exchange rates

Currency supply

Demand for goodsin foreign currencies

Demand for investmentsin foreign currencies

Cash flow from domesticinvestments

Money supply from central bank

Central bank interventions

Exchange rate regimes

Expected exchange rates

Currency demand

Bimetallism


Interwar period




10/33 22



Current exchange rate regimes


Bimetallism


Interwar period



Exchange arrangements with no separate legal tenderThe 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 specifiedforeign 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 fixedcentral rate that are wider than 1%(e.g. Denmark, Slovenia, and Hungary)


11/33 23



Crawling pegsThe exchange rate is adjusted periodically in small amounts at a fixedpreannounced rate or in response to changes in selective quantitativeindicators(e.g. Bolivia, Costa Rica and Tunisia)

Exchange rates within crawling bands

The exchange rate is maintained within certain fluctuation margins around acentral 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 therate of change and preventing undue fluctuations in the exchange rate.(e.g. Australia, Brazil, Canada, Korea, Mesiko, U.K., Japan, Switzerland, US)



Bimetallism


Interwar period




12/33 24





Bimetallism


Interwar period




13/33 25





Bimetallism


Interwar period




14/33 26





Bimetallism


Interwar period



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?


15/33 27



Trade balance surplus and deficit and what they mean


Bimetallism


Interwar period



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 netinvestors on the international capital market

On the other side, a trade balance deficit means:

- The country imports more than it exports. The citizens spend moremoney for foreign goods than they earn from foreign trade

- If you spent more money than you earn, you have to borrow money tofinance 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 tofinance your deficit anymore

Politicians prefer a trade balance surplus!

Bi t lli


16/33 28



Exchange rates and the trade balance


Bimetallism


Interwar period



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$

Americans buy German products Germans dont buy American products

American goods cost a lot of

Exports increaseImports decrease

Trade balance surplus!

Bi t lli


17/33 29



Exchange rates, the trade balance and public debt


Bimetallism


Interwar period



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?)


18/33


19/33

31



2.1 Exchange rate systems


2.3 International political risk

2.4 Culture



20/33


21/33

33




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 subsidizedandothers get more expensive due to tolls raised (toll wars possible)

Withholding taxes: Whenever dividends and interests are paid, a tax israised on that capital income that would not apply for domestic investors

Interventions on the currency market: Exchange rates are influenced bycentral bank interventions

Control of capital flows: In some countries, capital imports and exports arecontrolled by the government

Control of work force movements: Some people are not allowed to leavetheir country or to work in a country (asylum seeker etc.)

Missing protection of foreign investors: Foreign investors might beexpropriated by local investors or mistreated by local judges


22/33

34




Psychological restrictions

Availability bias: People tend to think that they are well informed, if there is alot of information easily available, even though the information might beirrelevant. They prefer to invest into domestic markets because they have a lotof information available

Firm visibility: Closely related to availability is visibility. If a company is visiblefor investors, they are more willing to invest into that company, giving domesticcompanies an advantage, even though they might not be better

Insecurity and exchange rates: Exchange rates are an additional riskyvariable influencing the investment return. This gives a feeling of insecurity thatpeople try to avoid by cancelling foreign investment, ignoring that exchangerate risk could be actively managed

Cultural factors: It is widely observed that people tend to invest into countrywith a comparable culture. Common religion and a similar genetic backgroundincrease capital flows between the two countries. Also, comparable culture canend up in comparable tastes and the same kind of products are demanded

All these reasons lead to a so called Home Bias of investors


23/33

35




Physical restrictions

Transaction costs: Buying and selling currencies is costly, because this isdone 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 toprocess all information available. Wrong trades can happen

Asymmetric information: Local investors and analysts might have betterinformation about investment opportunities in their country. Or at least this isfeared by foreign investors

Incomplete contracts: It is not possible to write a complete contract thatforesees and manages every single possible contingency. People might refrainfrom international trade because there are sometimes no accepted rules aboutwhat happens in an unforeseen contingency (which court decides this?)


24/33

36




Market segmentation and international financial management

If we only had one global market for goods and capital, international financialmanagement 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 financialmanagement, because we talk about two different markets

International financial management must be aware of the restrictionsmentioned 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 financingstrategies in different financial markets


25/33

37




Summary of the chapter

Market imperfections stem from political, psychological and physicalrestrictions

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 processingcapabilities and general human behavior that lead to non rational acting andsegment the markets

Physical restrictions limit the trading of goods due to costs of transportation,

dealing, information and capacities


26/33

38






2.4 Culture



27/33

39




International political risk

Foreign investors face political risk of changing laws in the countries theyproduce and distribute.

Types of international political risk

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

Diversification of country risk

Higher hurdles for governments to impose negative actions

Transfer risk

Operational risk

Control risk

Capital flow controls,withholding taxes

Policies via local operations

Expropriation/Nationalization


28/33

40




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

Factors for evaluating political risk

Available assessment on country risk (political risk + credit risk)

Rating agencies

Morgan Stanley

Euromoney


29/33

41




What foreign investors usually search for

Stable political conditions

No general social conflict

Stable economic prospects

Predictable behavior of administration and civilservants

National reputation of sticking to contracts

An independent and fair jurisdiction

A consistent set of laws

A good relationship between the country and thehome country of the foreign investors


30/33

42






2.4 Culture



31/33

43



-Hall

-Hofstede

2.4 Culture


32/33

44



Context orientation

Space orientation

Time orientation

Speed of information

High context culture

Low context culture

Privacy sphere

Territory

Monochronic orientation

Polychronic orientation

High

Low

2.4 Culture

Dimensions and types of culture: Hall


33/33

Documents

Chapter 2 Foundations of International Financial Management