INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1. INBU 4200INTERNATIONALFINANCIAL MANAGEMENT Professor Michael Palmer Leeds School of Business University of Colorado at Boulder Fall 2007 Lecture 1: Introduction to Course and Globalization

2. Leading Off: What is your Current Understanding of International Finance? • What are the foreign exchange symbols from the previous slide? • ¥, £, and € • What is the approximate current spot exchange rate for the: • Yen, Pound, Euro. • What has the U.S. dollar done since the beginning of the 2007 against the major currencies of the world (Yen, Pound, and the Euro)? • Strengthened or weakened • Which of the following currencies are pegged to the U.S. dollar? • Argentina Peso, Chinese Renminbi (yuan), Thai baht, South Korean Won, Hong Kong dollar,

3. Leading Off: What is your Current Understanding of International Finance? • What country currently has the lowest interest rates? Which has the highest interest rates? • United States, Japan, U.K., Germany, Australia, Switzerland • The largest foreign exchange market is located in what city? • New York, Tokyo, London, Paris, Singapore • How many countries are currently in the European Union (EU)? What is its population compared to the US? • 6, 15, 25, 27, 29? • Which of the following 14 countries is not a member of the eurozone (i.e., does not use the euro as its national currency)? • Greece, Italy, Ireland, Portugal, France, Germany, Spain, Belgium, Netherlands, Luxemburg, Austria, Finland, Slovenia, The United Kingdom

4. Leading Off: Who are the Major Personalities Today? • Who is the current chair of the US Federal Reserve? • Alan Greenspan, Ben Bernanke, Henry Paulson • Who is the current chair of the Bank of England? • Gordon Brown, Mervyn King, Tony Blair, Alistair Darling • Who is the current chair of the European Central Bank? • Nicolas Sarkozy, Jacques Chirac, Jean-Claude Trichet, • Who is the current chair of the Bank of Japan? • Shinzo Abe, Toshihiko Fukui, Junichiro Koizumi

5. Real Time Spot Currency Rate Quotes • Source for real time spot foreign exchange rates: • http://www.fxstreet.com/rates-charts/forex-charts/ • Go to “live streaming rates.” • Note bid and ask prices (bid first, and ask second). • The ask price is what you can buy 1 unit of the first currency in the two currency sequence for and the bid price is what you can sell 1 unit for: • For example: EUR/USD (ask is price to buy 1 euro; bid is price if you sell one euro). • For example: USD/JPY (ask is price to buy 1 US dollar, bid is the price if you can sell 1 dollar).

6. Tracking the U.S. Dollar in 2007 • Source for historical exchange rates (charts and data) • http://fx.sauder.ubc.ca/ • For Charts, go to “Plot Interface” link. • For Base currency: select U.S. dollar • For Target currency: select specified foreign currency • Choose appropriate time horizon • Select Notation: • Price notation = U.S. dollars per 1 unit of the foreign currency (American terms quote) • Volume notation = Foreign currency units per 1 unit of the U.S. dollar (European terms quote). • For actual data, go to “Database Retrieval” link.

7. Currencies Pegged to U.S. Dollar • A “currency peg” is an arrangement whereby a government ties its domestic currency’s value to an external currency at a stable rate, e.g., 1 to 1. • Very little market movement is allowed around this pegged rate. • The government pegging intervenes in the market whenever the currency moves above or below the peg to restore its pegged rate. • Selling if it gets too strong and buying if it get too weak.

8. Argentina Peso • Peg set at 1:1 in early 1990s, dropped in 2001

9. Chinese Renminbi (aka Yuan) • Peg set at 8.28:1 in 1997; dropped in 2005

10. Thai Baht • Peg set at 25, Peg Dropped in 1997

11. South Korean Won • Peg set at 800; dropped in 1997

12. Hong Kong Dollar: Longest Running Peg: October 1983 – Present @ HKD7.8/USD

13. Interest Rates, August 15, 2007 • Source: http://www.economist.com/markets/indicators/

14. Interest Rates, January 11, 2007

15. Relationship of Exchange Rates to Interest Rates: Australian Dollar

16. Relationship of Exchange Rates to Interest Rates: Japanese Yen

17. Carry Trade Strategy in 2007 • A carry trade currency trade strategy involves: • Borrowing in the country with a low interest rate. • Selling that currency on foreign exchange markets for a currency with a high interest rate (short sale). • Investing in the country with the high interest rate. • A carry trade strategy will tend to: • Weaken the low interest rate currency • Strengthen the high interest rate currency.

18. Largest Foreign Exchange Market • The largest foreign exchange market is located in what city? • New York, Tokyo, London, Paris, Singapore • Approximately 30% of the world’s daily foreign exchange transactions take place in London. • The daily foreign exchange market is estimated at about $2 trillion dollars. • Thus London accounts for $600 billion per day! • New York is second, Tokyo third. • All foreign exchange markets are OTC markets

19. European Union Countries • How many countries are currently in the European Union? • 6, 15, 25, 27, 29? • EU began with 6 countries on March 25, 1957 • Treaty of Rome: France, Germany, Italy, Belgium, Netherlands, Luxemburg (first called the European Common Market) • The United Kingdom joined on January 1, 1973. • Greenland left the EU in 1985. • Expanded to 15 by the 1990s (East Germany became part of the EU in 1990). • Grew by 10 more to 25 on May 1, 2004 (including Poland) • Expanded to 27 with 2 more countries, Bulgaria and Romania, joining on January 1, 2007 • EU Population = 450 million (US = 300 million)

20. European Union: Member Countries

21. Eurozone Countries • Which of the following 14 countries is not a member of the eurozone (i.e., does not use the euro currency)? • Greece, Italy, Ireland, Portugal, France, Germany, Spain, Belgium, Netherlands, Luxemburg, Austria, Finland, Slovenia, The United Kingdom • The UK is not a member. Slovenia joined the eurozone on January 1, 2007. • There are now 13 Euro-zone countries • Note: Cyprus and Malta are expected to join the eurozone on January 1, 2008.

22. Who are the Major Personalities Today? • Who is the current chair of the US Federal Reserve? • Alan Greenspan, • Henry Paulson • Ben Bernanke, • Who is the current chair of the Bank of England? • Gordon Brown, • Tony Blair • Alistair Darling • Mervyn King, • Who is the current chair of the European Central Bank? • Nicolas Sarkozy, • Jacques Chirac, • Jean-Claude Trichet, • Who is the current chair of the Bank of Japan? • Shinzo Abe, • Junichiro Koizumi • Toshihiko Fukui,

23. What is GLOBALIZATION? • What do you think of when you hear, or read this term? • What are some possible definitions you can offer?

24. Globalization Defined • The act of becoming world wide in scope. • Thus, it can be viewed as an increasingly freer flow of • Goods, • Services, • Companies, • People, • Ideas (technology; R&D), and • Capital • . . . across national borders. • Refer to Appendix 1 for a discussion of the history of globalization, Appendix 2 for examples of globalization by business functions and Appendix 3 for contemporary issues surrounding globalization.

25. Thomas Friedman’s (The World is Flat) Definition • “Globalization as the inexorable integration of markets, transportation systems, and communication systems to a degree never witnessed before -- in a way that is enabling corporations, countries, and individuals to reach around the world farther, faster, deeper, and cheaper than ever before...” • Source: http://www.thomaslfriedman.com/longitudesprologue.htm

26. Globalization’s Potential Impacts on Business Firms • Impacts on the target markets where companies sell and/or buy. • consumer goods • industrial goods, and • financial services • Impacts on where companies source the factors of production for their enterprises: • capital (where firms finance), • technology, • labor

27. Globalization’s Potential Impacts on Business Firms • Impacts on mergers and acquisitions. • Firms can now be the target of or acquirer of foreign firms. • Buying other firm’s technology, market share, patents, etc. • Expands the “opportunity set” for acquiring firms. • Impacts on types and degree of risk associated with an increasingly global enterprise. • Associated with the unique business and financial risks that confront firms in a global environment. • Exchange rates, global competition, cultural differences, foreign governments, variations in economic environments.

28. Globalization’s Potential Impacts on Investors • Positive Diversification Impacts. • Investors can now construct portfolios consisting of a combination of domestic and foreign issues. • Including both stocks and bonds. • And in different currencies. • This can have an impact on a Portfolio’s Systematic Risk. • Systematic risk is the “market risk” associated with any one domestic portfolio. • For a one market portfolio, this risk is nondiversifiable. • If asset returns show low correlations across countries, investors can reduce a portfolio’s systematic risk through an internationally diversified portfolio. • Increase risk: For example: exchange rates, country risk, contagion market effects.

29. Globalization’s Potential Impacts on Countries and Governments • Globalization has resulted in countries becoming more open. • Exports as a percent of GDP (1950 to 2003) • Germany: 6.2% to 31.3% • Mexico: 3.5% to 26.3% • Canada: 13.9% to 33.4% • Japan: 2.3% to 10.4% • France: 7.7% to 20.3% • United States: 3.0% to 6.5% • Globalization has the potential to exert pressures on domestic rates of inflation • Through import prices. • Impact of China on consumer and commodity prices.

30. How Does International Business Differ from Domestic? • Dealing with: • Different cultures • Different governments • Different legal system and laws • Different business cultures • Different consumers • Different economies and economic conditions • Different currencies

31. Dealing with Exchange Rates • One of the major differences between global firms and purely domestic firms, is that the former need to deal in different currencies and are therefore subject to possible exchange rate risk. • Exchange rate risk results from a firm having exposure in a foreign currency and that foreign currency moves in a manner detrimental to the firm. • Refer to Appendix 5 for a discussion of the differences between domestic and international finance (including exchange rate risk).

32. Quick History of Exchange Rates • After WWII • World turns to the US and agrees on a system of stable exchange rates to renew confidence in the global system. • After Bretton Woods • World turns to floating exchange rates.

33. Foreign Exchange Risk • Critical questions for global company: • How will changes in these foreign currencies affect their consolidated financial performance? • Revenues and Costs components. • How volatile are the currencies it is dealing in? • Short term moves and longer term trend changes. • Managers must be aware of this potential volatility and understand the techniques for managing this risk? • This is a theme we will be developing throughout the course. • See the next three slides for examples of long term trend changes and intermediate term and short term currency movements. See Appendix 5 for more detail.

34. Trend Changes: The Euro Against the Dollar • Source: http://fx.sauder.ubc.ca/

35. Intermediate Moves About the Trend: Euro in 2007

36. Short Term Moves: British Pound: Noon (MST) January 11, 2007 (Surprise interest rate increase)

37. Globalization of Financial Markets • Definition of Financial Market Globalization Process: The integration of a country's domestic financial system into the international arena. • And, as a result, individual domestic financial markets become so closely integrated with others that, taken as a whole, they can be considered as a single market. • Financial market globalization has resulted from • (1) the liberalization of capital flow restrictions worldwide and • (2) advancing technology (in communications).

38. The Globalization of Financial Markets: Summary • Financial markets now function in many ways as one integral whole covering the globe. • This is represented by: • Large trading volumes across borders. • Securities of different nations (corporate and government issues) trading in many major financial market centers. • Financial events in one country affect other countries. • Major central bank actions, U.S. stock market. • Today, companies look at funding possibilities in financial markets around the world. • Today, investors can select from opportunities offered by a vast array of countries.

39. Appendix 1: The History of Globalization The following slides discuss the history of globalization in general and of financial markets in particular

40. Quick History of Globalization • About 200 years ago: Free Trade Era • Second British Empire and Industrial Revolution • Last half of the 18th Century. • New (Free Market) Economic Thought of the Time • Adam Smith (1776) and David Ricardo (1817) • Both showed how countries would benefit from free trade. • WW I (1914-1918) – 1940s: Abandonment of Free Trade • High protectionism especially during Great Depression (1929 – early 1940s) • Hawley-Smoot Tariff Act in U.S. (1930) imposed the highest duties on agricultural products and manufactured goods in U.S. history.

41. Quick History of Globalization • Period Immediately After WWII (1939 – 1945): Slow Return to Globalization Process • Formation of GATT in 1948 • Goal: To reduced tariffs and expand world trade. • How: Through trade rounds among member countries. • Bretton Woods Agreements in 1944 • Goal: To restored exchange rate stability. • How: Return to fixed exchange rates to promote world trade. (created the Bretton Woods International Monetary System) • International Monetary Fund established in 1944 • Goal: To maintain exchange rate stability by assisting countries who’s currencies were under attack. • How: By providing short term funds for intervention.

42. Quick History of Globalization • 1970s and 1980s: Acceleration of “goods” trade liberalization among world’s industrial countries and eventually among the developing counties. • Accounted for by the continuing impact of GATT, and • Impact of negotiated trade agreements and regional trading blocs (e.g., the EU and later NAFTA) on cross border trade. • 1994: Establishment of WTO • Goal: To replace GATT as the world’s forum for trade negotiations and the settlement of trade disputes. • 2006/07 Failure of Doha Round (2001 agricultural subsidies, manufacturing and services trade talks). • What does this mean for the future of goods globalization?

43. Brief History of Financial Market Globalization: Early 20th Century • After the severe financial and economic disruptions of the 1930s, many government policy makers questioned whether free capital flows and liberalized capital markets were desirable. • As a result, many countries restricted outward capital transfers either because • (1) they preferred their capital to be invested within their domestic economies or • (2) because they wished to prevent downward pressure on their exchange rates. • Countries also put severe restrictions on inward investments, many fearing foreign control of their domestic companies, economies and/or financial markets.

44. Brief History of Financial Market Globalization: Mid 20th Century • During the 1950s and 1960s, each countries’ financial institutions/markets and their regulatory structures evolved in relative isolation from the rest of the world. • During those years, most countries, including the United States, imposed restrictions on international capital movements. • 1964 U.S. Interest Equalization Tax; a 15% tax imposed on foreign borrowers in the US (lifted in 1974). • 1965 Foreign Credit Restraint Program restricted the ability of U.S. banks to extend loans to US and foreign borrowers for foreign purposes (lifted in 1974).

45. Brief History of Financial Market Globalization: Late 20th Century • During the 1980s, capital account liberalization was seen as an essential step on the path to a country’s economic development. • In many ways this was analogous to the earlier reductions in barriers to international trade in goods and services. • Refer to Appendix 3 for a comparison of the pace of goods and financial market globalization since 1980. • Capital account liberalization meant the reduction in restrictions on cross border capital flows. • Portfolio investment and foreign direct investment.

46. Financial Market Deregulation in the 1980s • In the 1980s, the capital markets underwent extensive reforms. • The markets became increasingly internationalized, as government deregulations allowed foreign-owned banks to extend their operations in local markets. • There was also extensive restructuring of domestic financial market as interest-rate ceilings were abolished and competition between different financial institution intensified. • The lead in financial market deregulation occurred in the industrial/developed countries.

47. Deregulations of Financial Markets Among Developed Countries • United States: Abolished capital controls in 1974. • The removal of the Glass Steagall Act in 1999. • U.K.: Lifted currency inconvertibility restrictions in 1979. • U.K. “Big Bang” in 1986 (LSE; stock market deregulations) • Japan: “Big Bang’ in 1996-98 • Lifting restrictions on capital movements in and out of Japan including restrictions preventing non-banks from conducting foreign exchange business • Japan: Phasing in of universal financial institutions legislation (2005/2006) • EU: Lisbon Agreements (2000): goal of opening up financial markets and promoting single market in financial services by 2010.

48. Deregulations of Financial Markets Among Developing Countries • Compared with the situation in industrial countries, financial market liberalization occurred at a slower pace in developing countries. • After the “Third World Debt Crisis” (in the early 1980s), bank loans to developing countries dried up and a result these countries needed to attract new sources of capital. • By the 1990s many developing countries had greatly liberalized their foreign investment regimes, as well as reduced their controls over capital movements. • Individual country stock markets were established or expanded as part of developing country financial sector reforms. • These markets have been used in many developing countries to facilitate privatization by attracting foreign portfolio capital. • Process slowed somewhat by the Asia currency crisis in 1997.

49. Appendix 2: Globalization by Business Functions The following are examples of globalization impacts on selling, producing, and financial services on selected U.S. companies

50. Examples of Business Functions • Selling (Products) Function • McDonalds Corporation • Starbucks • Production (of Products) Function • Nike Corporation • Financial Services (commercial banking, investment banking, insurance, asset management) Function • Citigroup