OVERVIEW : CHAPTER 1

1. OVERVIEW : CHAPTER 1 • What is study of International Finance ? • Goals of MNC • Theories of International Business

2. WHAT IS THE STUDY OF INTERNATIONAL FINANCE ? • Making investment and financing decisions in a global market • Cash flows associated with these decisions • Risks associated with these cash flows • The international financial markets

3. OVERVIEW : INTERNATIONAL FINANCIAL MANAGEMENT Corporate Manager (Agent) Investment (Involving Foreign Curency Transactions & Risks)) Financing (Involving Foreign Curency Transactions & Risk) Global Financial Market Mutinational Corporate Balance Sheet Global Product Market Cash Outlay Cash Revenue Cash Expense Net Cash Flows Assets Liabilities Short Term Short Term Curent Assets Current Liabilities Long Term Long Term Land Debt Plant Equipment Equity (Owner) Corporate / Govt Securities Bonds Stock Cost of Capital Minimize: Cost of Debt Cost of Equity Capital Budgeting Maximize: NPV / IRR Shareholder’s Wealth Maximization (Agency Problems) * Foreign Currency Market & Exchange Rates * Foreign Exchange (FX) Risk * International Trade, BOP, Flow of Funds & Exchange Rates * Government’s Role * International Parity Conditions * Measuring and Managing FX Risk * Raising & Investing Capital in a Global Market

4. What’s Special about • “International” Finance? • 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.

5. Yen and Euro: 1990 - 2001

6. FX Risk: In-Class Exercise For each one of the four companies, indicate if the net cash flows will increase, decrease not change during both the 1994-95 and the 1996-97 periods, based on the plots of Yen and Euro prices:

7. Multinational Corporations (MNC) • 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 labor and capital equipment in a third country and sell their output in various other national markets.

8. What’s Special about “International” Finance? • 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.

9. What’s Special about “International” Finance? • Market Imperfections • Legal restrictions on the movement of goods, people, and money • Transactions costs • Shipping costs

10. What’s Special about “International” Finance? • Expanded Opportunity Set • It doesn’t make sense to play in only one corner of the sandbox: Consumption, Production, Financing, and Investment. • True for corporations as well as individual investors.

11. 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?

12. Maximize Shareholder’s Wealth Discounted Cash Flow Valuation Model: where E (CF$,t ) = expected cash flows to be received at the end of period t (domestic firm) n = the number of periods into the future in which cash flows are received k = the required rate of return by investors

13. Valuation Example 1: Domestic Firm

14. Maximize Shareholder’s Wealth with FX Risk(1) Valuing International Cash Flows • where E (CFj,t ) = expected cash flows denominated • in currency j to be received by the • U.S. parent at the end of period t • E (ERj,t ) = expected exchange rate at which • currency j can be converted to • dollars at the end of period t • k = the weighted average cost of capital of • the U.S. parent company

15. New International Opportunities More Exposure to Foreign Economies More Exposure to Exchange Rate Risk More Exposure to Political Risk Maximize Shareholder’s Wealth with FX Risk (2)

16. Valuation Example 2: MNC

17. MNC Valuation: In-Class Exercise

18. SOURCE OF MNC’S CASH FLOWS Depends On Methods Of Doing International Business: • International Trade • Licensing • Franchising • Joint Venture • Acquisition of Existing Operation • Establishing New Foreign Subsidiaries

19. THEORIES OF INTERNATIONAL BUSINESS • Imperfect Markets Theory • Comparative Advantage Theory • Product Cycle Theory

20. IMPERFECT MARKET THEORY • Factors of production are immobile • Land, Labor, Capital and Technology

21. PRODUCT CYCLE THEORY • Start with a unique product controlled by one firm in one country • The firm exploits that product domestically • The firm expands overseas

22. COMPARATIVE ADVANTAGE THEORY • Specialization and productive efficiency • Classical theory of international trade

23. The Theory of Comparative Advantage • Definition: a comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party

24. Comparative Advantage: In- class Exercise

25. Comparative Advantage: In- class Exercise

26. Comparative Advantage

27. OVERVIEW : CHAPTER 2 • Components of the Balance of Payments (BOP) • Composition of each component • How are the BOP components affected • Policy implications for managing BOP

28. Uses of BOP • Source and Use of Funds Statement • Predict Fx Rates and Pressure on Fx • Political/Credit Risk: Assess • Economics Health: Assess • How Country Manages its’ Resources

29. BALANCE OF PAYMENTS ACCOUNTING PRINCIPLES (1) • Economic transactions between domestic and foreign residents. • Viewpoint of one country (i.e. USA). • Domestic assets and domestic liabilities are changed using debits and credits.

30. BALANCE OF PAYMENTS ACCOUNTING PRINCIPLES (2) • Double-entry accounting system. • If a transaction creates supply of the nation's currency in the foreign exchange market it is recorded as a Debits (eg Imports) • Debits are used to increase assets and decrease liabilities. • If a transaction creates demand for the nation's currency in the foreign exchange market it is recorded as a Credit (eg Exports) • Credits are used to increase liabilities and decrease assets. • Since the foreign exchange market clears (i.e. supply = demand): DEBIT = CREDIT

31. BALANCE OF PAYMENTS ACCOUNT COMPONENTS • Current Account • Merchandise • Services • Net income from investments • Unilateral transfers (Gifts and grants) • Capital Account • Short term capital flows • Long term capital flows • Official Reserves Account

32. BALANCE OF PAYMENTS ACCOUNTING IDENTITY • Current Account Balance plus Capital Account Balance plus Official Reserves Balance equals zero • Statistical error

33. Basic of Credit or Debit • Increase in Demand for $ or $ comes to USA (Export from USA) • Increases in Supply of $ or $ leaves USA (Imports by USA) • Identify: (A)Which Category will the transaction go to (B) Is it a Debit or Credit (C) Estimate Balances in Various categories Credit Account Debit Account

34. World USA BOP Current Account Big Item USA Capital Account Reserves + + Statistic Error • *Merchandise; * Service; • Inv. Income; Unilateral Transfer + = 0

35. MERCHANDISE TRANSACTIONS • Largest component of the Current Account, • It consists of: • Exports: When US producers sell their products abroad, buyers (foreigners) supply their own currencies and create a demand for dollars in the FX market • It is recorded as a credit transaction (+) • Imports: When US residents buy products from abroad, they supply dollars (and create a demand for foreign currencies) in the FX market. • It is recorded as a debit transaction (-) • Merchandise Export - Merchandise Import: Largely Negative (for US) • Examine US Merchandise Trade Balance Data

36. SERVICE TRANSACTIONS • Export and Import of Services • Travel / Transportation / Financial / Insurance / Computer & Information / Construction / Tuition Fees • The net difference (export - import) for US is: • Service Exports - Service Imports: Generally positive • Smaller then Merchandise Export - Imports • Has grown over the past years

37. OTHER CURRENT ACCOUNTS • Net Investment Income • Income (interest, dividend, profit etc.) received from US investment abroad minus income paid to foreigners investing in the US • Mostly declining in recent years • Unilateral Transfers • Net of gift received from and given to foreign countries • Examine US Current Account Statistics

38. CAPITAL ACCOUNTS (1) • Records changes in asset ownership of a country • Real asset (factories, building, land, etc.) • Financial assets (securities: stocks, bonds, bank loan, deposit)

39. CAPITAL ACCOUNTS (2) • Capital account transactions: • Reflects the flow of capital in and out of the US • Affects the FX market: • Debit: • Increase in US investments overseas • Decrease in overseas investments in the US • Capital Outflow from the US • It creates a supply of $ in FX market • Credit: • Decrease in US investments overseas • Increase in overseas investments in the USI • Capital Inflow into the US • It creates a demand for $ in FX market

40. OFFICIAL RESERVE ACCOUNT • Credit: Decrease in US Government’s holding of FX and gold: transactions by Fed or US Treasury • Debit: Increase in US Government’s holding of FX and gold: transactions by Fed or US Treasury • Current Account Balance + Capital Account Balance + Official Reserve Account = 0 • Used to offset the net effects of the Current and Capital Account balances.

41. Balance of Payments Accounting Entries: A Summary (1)

42. Balance of Payments Accounting Entries: A Summary (2) Balance of Trade (BOT) = (A - B) + (C-D) Current Account Balance = (A-B) + (C-D) + (E-F) + (G-H) Capital Account Balance = (I-J) Official Reserve Balance = (K-L) Current Account + Capital Account + Official Reserve = 0

43. Euro Bond • Neither Euro currency, nor European Bond market • Bond in a currency other than that of country in which it is issued • Euro bond denominated in Japanese Yen = Euroyen bond • Australian company issue in Japan, Euro dollar bond denominated in US $; American Firm sells Eurodollar bond issue in London • High Liquidity; Small Par Value • Choose which country to offer bond, lower cost of fund

44. BOT and TD • BOT = E – I ( in merchandise, service) • Like Net Income figure • NI goes from -$200 to -$100 • NI or BOT • TD is a “ Loss” account. • TD goes from -$200 to -$100 • Loss or TD 

45. INFLATION & BOT • If domestic inflation / price levels increase: • Export will decrease • Imports will increase • BOT will decrease / TD will increase • If domestic inflation / price levels decrease: • Export will increase • Imports will decrease • BOT will increase / TD will decrease

46. NATIONAL INCOME (GNP) & BOT • If national income / prosperity increases: • Imports will increase • Exports will not change • BOT will decrease / TD will increase • If national income / prosperity decreases: • Imports will decrease • Exports will not change • BOT will increase / TD will decrease

47. PRICE OF DOLLAR & BOT • If the price of $ increases: • Export will decrease: • Imports will increase: • BOT will decrease / TD will increase • If the price of $ decreases: • Export will increase: • Imports will decrease: • BOT will increase / TD will decrease

48. GOVERNMENT POLICY & BOT • Methods used by governments to reduce BOT deficit: • Currency depreciation • Protectionism • quotas • tariffs • Regulating flow of international capital

49. Quota & Tariff (1) • Quota: Quantity of Items which can be imported into USA from foreign country. • Tariff: Like a tax •  in Tariff  US govt. increases tax on imported goods from foreign country

50. Quota & Tariff (2) • USA govt.  tariff • =  Quota of imported goods from foreign country • Imports will  • Export will not change • BOT will increase/TD will decrease.