International Finance Pr. Ariane Chapelle ariane.chapelle@ulb.ac.be

1. International Finance Pr. Ariane Chapelle ariane.chapelle@ulb.ac.be site : http//solvay.ulb.ac.be/cours/chapelle

2. Contents • Introduction : The International Financial Environment • Part 1 : Fundamentals of International Finance • Exchange rate determination • Parity conditions : PPP & interest parity • Balance of payments approaches • Other models • Monetary integration in the European Union • The case for a greater fixity in exchange rates • Optimal single currency zone • The IMF and the provision of finance • A critique of the IMF approach • International debt crises : a few examples

3. Contents • Part 2 : International Corporate Finance • Why do firms extend internationally? • FDI theory and strategy • Decision case : Investing in Indonesia • Multinational capital budgeting • Financing the Global Firm : • Sourcing equity globally • Financial structure and international debt • Foreign Exchange Exposure • Transaction exposure • Operating exposure • Managing Multinational Operations : • International tax management& Repositioning funds • Working capital management + decision case • International trade operations

4. Contents • Reference textbook • Moffet, M., Stonehill, A. and Eiteman, D., Fundamentals of Multinational Finance, Addison Wesley ed., 2003. • Other references • De Grauwe, P., « The Economics of Monetary Union », Oxford University Press ed., 2003. • Gibson, H. « International Finance », Longman ed., 1996. • Copeland, L., « Exchange rates and international Finance » third edition, Prentice Hall ed., 2000.

5. The international financial system • Introduction • Different forms of exchange rates organisation : • fixed • floating • managed • monetary unions • Questions of • adjustment of balance of paiements • liquidity provision in the system • international money deficition and usage

6. Full Capital Controls Impossible Trinity Monetary Independence Exchange rate stability Pure float Monetary Union Full Financial Integration The international financial system • Impossible Trinity : • Exchange rate stability • Full financial integration (free capital flows) • Monetary independence • Is there a best system? • What design of institutions?

7. The international financial system • International money • Characteristics : International money should be : • defined • convertible • inspire confidence • store of value • Summary issues & concerns of financial markets : • Adjustments of BOP • Provision of liquidity • -> 4 different systems address these 2 issues.

8. Exchange rate determination Approaches for exchange rate determination : 1. Parity relations Purchasing Power Parity (PPP) Interest Rate Parity (CIP ; UIP) 2. Balance of payments approaches FX such that BOP in equilibrium Adjustment mechanisms 3. Other approaches Dornbusch overshooting model Portfolio approach News approach Bubbles and chaos

9. Purchasing Power Parity 1. Parity Relations - PPP • Absolute Purchasing Power Parity - Definition • P = S.P* : “law of one price” • Domestic Prices = Exchange Rate . Foreign prices • P and P* : general price indices • Rearranging : S = P/P* • The spot exchange rate between 2 currencies is equal to the ratio of general price levels between the 2 countries.

10. Purchasing Power Parity • Absolute Purchasing Power Parity - Hypotheses • Hypotheses • No transports costs • Perfect information (on prices in both countries) • Homogeneous goods • No trade barriers -> Equality brought by arbitrage • Definition of arbitrage : buy and resell without risk but with a profit • Example of arbitrage : buy 20 kg of gold in Belgium at 50.000 euros, and resell is immediately in France at 53.000 euros. Question : is this imaginable for any goods?

11. Purchasing Power Parity • Relative Purchasing Power Parity - Definition • S = b.P/P* • Prices across countries might differ by a constant factor “b”, accounting for transport costs and information costs. • Focuses on the movements in the exchange rate and the extent to which they reflect differential inflation: • dS/S = dP/P - dP*/P*

12. Purchasing Power Parity • PPP absolute & relative - Interpretation ? • No precision of causality : does the prices determine the FX rate, or the reverse? • Goods included : traded & non traded? If yes, hypothesis of perfect substitutability and similar productivity levels. • If only traded goods included : PPP close to a tautology • Short-run or long-run anchor? -> alternative : “cost parity theory” • (more seducing, but same nature of problems)

13. Purchasing Power Parity • PPP absolute & relative - Theoretical criticisms (6) • Information costs, transport costs, trade barriers : exist, and could change over time. • The direction of causality is unclear -> exchange rates could determine prices. • All disturbances are monetary, or more important than real ones ->no account of productivity changes in one country. • No account of productivity differential between traded & non-traded goods sectors. • Ignores the role of income in determining exchange rates, and its consequences on a change in demand. • No role of capital flows. Sole focus on exchange of goods.

14. Purchasing Power Parity • PPP absolute & relative - Empirical testing • Tests of commodity arbitrage, of the absolute version and on the relative version. • Methods used: • Regressions • Plots of data • Cointegration tests (for the long-term relationship) -> Commodity arbitrage appear not to maintain the law of one price. Little empirical support. • Recent multivariate cointegration tests : some support (relative version) for some large currencies.

15. PPP - Illustration

16. Fisher Effect 1. Parity Relations : Fisher - CIP - UIP • The Fisher Effect - Definition • The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. • That is : i = r +  ; i* = r* + * • Empirical tests show that the Fisher effect generally exists for short-maturity government securities, but are inconclusive for longer maturities.

17. Fisher Effect • The Fisher Effect - Definition • The International Fisher Effect (or Fisher-open) states that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries. • That is : • Or, in a simplified form: • Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates

18. Fisher Effect • The Fisher Effect - Empirical evidence • Empirical tests lend some support to the international Fisher effect, despite large short-run deviations. • A more serious criticism comes from studies suggesting the existence of a foreign exchange risk premium for most major currencies. • Also, speculation in uncovered interest arbitrage creates distortions in currency markets.

19. Interest Rate Parity 2. Parity Relations - CIP • Covered Interest Rate Parity - Definition • CIP states that returns between assets in different countries should be equalised. • If they are not, equalisation is brought by arbitrage. • It gives : • (1+it*) . Ft/St = (1+it) • Return of foreign invt = return of domestic invt • where : • it* = foreign interest rate ; it = domestic interest rate • Ft = forward exchange rate • St = spot exchange rate

20. Interest Rate Parity • The Forward Rate • A forward rate is an exchange rate quoted today for settlement at some future date • The forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be bought or sold forward at a specific date in the future (typically 30, 60, 90, 180, 270 or 360 days) • The forward rate is calculated by adjusting the current spot rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies • The forward premium ordiscount is the percentage difference between the spot and forward rates stated in annual percentage terms

21. Interest Rate Parity • Covered Interest Rate Parity - Hypotheses • Assets : same risk, same maturity • No transaction costs • No information costs • No control on capital flows • Plus, the transaction in the forward market implies that there is no foreign exchange risk (risk that S changes while investing abroad). • Arbitrage : Ex. return greater abroad, we have : • (1+it*) . Ft/St > (1+it) -> Investors will buy spot rate and sell forward (to invest abroad), causing S to rise and F to fall, getting back to equality.

22. Interest Rate Parity • Covered Interest Rate Parity - Numerical example • Let : it*= 5% ; it= 4% ; St = 0.9€/$ • Then : • Ft= St (1+it)/ (1+it*)= 0.9 x 1.04/1.05 = 0.8914 = forward rate (one year) of € per $. The difference with spot rate reflects the difference of interest rates in each currency. • If the parity is not applied, we have : • (1+it*) . Ft/St > (1+it) or : Ft> St (1+it)/ (1+it*) • arbitrageurs will sell large amounts of € against $ at spot rate (0.9), pay i to borrow and lend at i*, and buy them back forward at F rate (>0.89), making profit with no risk. • Large selling amounts will make S to rise (€ depreciation) and F to decrease (forward rate appreciation).

23. Interest Rate Parity • Covered Interest Rate Parity - Empirical tests • Methods • Plot the different interest rates separately and compare • Test if deviations are significantly different from zero • Regressing the forward premium - the difference between spot and forward rate - on (i*-i) : by • fp = a + b(i*-i); • if b=1, a = 0, CIP holds (i*- fp=i) • Deviations not uncommon, supposedly due to : • transaction costs (to what extent?) • the existence of capital controls • the existence of political risks : risks of capital controls or taxes before funds are repatriated.

24. Interest Rate Parity • Uncovered Interest Rate Parity - Definition • UIP = CIP + foreign exchange risk • States that returns between assets in different countries should be equalised, plus a deviation accounting for exchange risk. It gives : • i* +  Se = i • where : • i* = foreign interest rate ; i = domestic interest rate •  Se = expected change in the spot exchange rate • This relation holds if the path of the exchange rate is known with certainty, or if arbitrageurs are risk neutral.

25. Interest Rate Parity • i* +  Se = i • States that if the foreign interest rate is higher than the domestic rate, then the domestic currency must be expected to appreciate, to maintain this relationship (otherwise : arbitrage). • Uncovered Interest Rate Parity - Hypotheses • Rational expectations, i.e., forward market is efficient • Risk neutrality of arbitrageurs • If risk aversion of arbitrageurs : introduction of a risk premium: i* +  Se - i = 

26. Interest Rate Parity • Uncovered Interest Rate Parity - Empirical evidence • Difficulties : • Assess expectations on S; • Joint test of rational behavior of investors and of market efficiency (ex. no bubble phenomenon) • General result : UIP does not hold • Very little empirical support • (possibly due to the existence of a risk premium)

27. Forward Market for foreign exchange • Next to arbitrageurs, another important group on the forex markets : speculators. They deliberately expose themselves to exchange rate risk. • Speculators will trade on the basis of the difference between f (forward) and se (spot expected) at a given time horizon. • Trade until f = se • Hypotheses underlying this relation: • Speculators are risk neutral • Not prevented from operating on the forward market • No transaction costs

28. Forward Market for foreign exchange • With rational behavior hypothesis, we have • st = ste + ut , ut being a random walk (mean : zero) • with the arbitrage relation : se= f • we have : st = ft-1 + ut (1) • meaning : ft-1 = non biaised estimator of St • (1) is the efficient market condition relating the actual spot exchange rate to the forward rate. • Tests over market efficiency of forward rates : • Difficulty : joint test, both on market efficiency and on fundamentals of the model supposed to derive se • Methods using regressions and serial autocorrelation tests

29. Forward Market for foreign exchange • Some results of the econometrical tests : • Empirical support of existence of a risk premium (time-varying), but no clear model of formation • The lagged spot rate (st-1) outperforms the forward rate at predicting the spot rate -> abnormal profits could have been made, trading on the basis of the difference between the current spot rate and the forward rate at a given time. • Survey data about expectations formation of agents : • Expected change in spot rates is not an unbiased predictor of actual change in the spot rate • Agents bias their estimation of spot rates, based on extrapolation of recent trend -> destabilising expectations on exchange rates.

30. Summary • Main results of the section : • Serious theoretical questions on PPP theory and few empirical support. • CIP theory includes the role of capital mobility and arbitrage. More empirical support of CIP while UIP does not hold empirically. • Relationship between spot and forward rates suggest the existence of a time-varying risk premium and some irrationality of market participants while forming expectations of exchange rates.

31. Summary • Important policy implications : • If agents form their expectations extrapolatively then a policy of “leaning against the wind” may be beneficial. • That is, a forex market intervention attempting to break a trend in the market. • The existence of a risk premium that assets domestic and abroad are not perfect substitutes, and that interest rates in any country may not be identical to those abroad, even with no particular expectations of spot rate changes. • It also implies that sterilised intervention may work.

32. BOP approaches • General idea : FX rates are adjusted so that the BOP is in equilibrium • Balance of Payments (BOP) - Definition : • Balance of paiements : sum of all the transactions between the residents of a country and the rest of the world • BOP = current account balance + capital account + financial account + changes in reserves • BOP = (X - M) + (CI - CO) + (FI - FO) + FXB • Current account = exports - imports of goods & services • Capital account = capital inflows - capital outflows = capital transferts related to purchase and sale of fixed assets.

33. BOP approaches • Balance of Payments (BOP) - Definition : • Financial account = financial inflows - financial outflows = net foreign direct investments + net portfolio investments • Current + Capital + Financial accounts = Basic balance • FXB : changes in official monetary reserves (gold, foreign currencies, IMF position) • Balance of payments (BOP) • In equilibrium : BOP = 0 • Deficit country : BOP < 0 • Surplus country : BOP > 0

34. BOP approaches • Deficit country (current account deficit) • X - M < 0 : too many imports compared to exports • Money supply > money demand (in domestic currency) • Too large amount of domestic currency : deflationary pressures

35. BOP - Adjustment Mechanisms • Automatic mechanisms: • Two mechanisms can be defined as fully automatic : • freely floating exchange rate system • fully fixed commodity standard (Gold standard) • Freely floating : no BOP problem : any disequilibirum leads to automatic adjustment of exchange rates. • Automatic market mechanism of the demand / supply market for foreign exhange. • Demand curve for foreign exchange (D) derives from the desire of domestic residents to purchase foreign goods, services and assets. • D is negativley related to exchange rate (S).

36. Domestic price of foreign exchange Supply of foreign exchange S0 Depreciation S1 Demand for foreign exchange Q of foreign exchange BOP - Adjustment Mechanisms S = FX rate = P/P* = amount of domestic currency per one unit of foreign currency. Ex. €/$ = S for Europeans. A depreciation of the domestic currency = a rise in S. Ex. S0= 1, S1 = 0.9. S1 : excess of demand= deficit of BOP (too many imports). A depreciation makes foreign goods more expensive, and D decreases to equilibirum.

37. BOP approaches 2. Balance of payments approaches • FX rates are adjusted so that the BOP is in equilibrium • In case of fixed exchange rates : • Government in charge of the BOP equilibrium • FX rates maintained via the change in currency reserves • In case of deficit : the central bank ease devaluation pressure by buying the domestic currency and selling foreign currencies (out of its reserves) and gold. If the disequilibrium is too large and the central banks run out of reserves, the domestic currency will devalue. • BOP disequilibrium are then used to forecast the evolution of FX rates. Ex. : the Thai baht.

38. BOP approaches • In case of floating exchange rates : • Deficit countries : FX rates are expected to depreciate , due to the excess supply of money. • Surplus countries : FX rates are expected to appreciate, due to the relative shortage of domestic currency. • In case of managed floats : • Changes on relative interest rates to influence the capital inflows or outflows impacting the BOP and the valuation of a currency. • Ex : rise in interest rates to increase money demand (capital inflows) and support the value of the currency. BOP trends helps forecasting such moves.

39. Summary • Possible policies for a deficit country : • let the FX rate depreciate and restore competitiveness, leading to a rise in X and a reduction in M (if FX rates are floating) • reduce the stock of money by direct intervention : buy domestic currencies against foreign currencies held in monetary reserves (if FX rates are fixed) • increase interest rates to attract capital inflows (financing the deficit) and to reduce demand for imports (monetary view)

40. Summary • Surplus country (current account surplus) • X - M > 0 : too many exports compared to imports • Money demand > money supply (in domestic currency) • Lack of domestic currency : inflationary pressures • Possible policies for a surplus country : • let the FX rate appreciate and decrease competitiveness, leading to a reduction in X, and an increase of M; • increase the supply of money by direct intervention : sell domestic currencies and buy foreign currencies, growing the monetary reserves, to avoid FX appreciation; • lower interest rates to discourage capital inflows (increase outflows) and to reduce financial surplus.

41. Summary • Adjustment issue - reminder • The deficit is not dependant of the exchange rate (in theory) • In practice, however : • prices and wages are sticky • some regional shocks can create asymmetric disequilibrium • large players like governments and financial institutions influence equilibrium • surplus and deficit countries experience asymetric pressures for adjustments • Problem of adjustments : central concern of government -> need for design of institutions

42. Other approaches • None of the models developped so far succeed to explain FX rates levels and volatility • No pattern found in FX behavior • Volatility of FX rates much higher than the fundamentals • -> several models tend to explain the excessive volatility: • Dornbush overshooting model • Portfolio approach • News • Bubbles • Heterogenous expectations • Chaos theory • etc.

43. Overshooting models • First model : Dornbusch (1976) • Try to explain the observed high volatility of FX rates. • States that the difference of speeds of adjustment between asset markets (rapid) and good markets (slow, due to sticky prices) determines exchange rates. • Long-run exchange rates are determined by real factors & monetary factors. • The exchange rate and price level are function of three exogenous variables : • the real money supply (m-p) • the domestic real income (y) • the foreign interest rate (i*) • Short-term adjustement of s beyond the long-term equilibrium levels (“overshooting”), leading to subsequent changes in levels.

44. Overshooting models • Overshooting model - Input • Dornbush’s model can provide an explanation for the large fluctuations in exchange rates. • The model has served as a basis for other models of the overshooting type : no full employment, imperfect currencies and assets substitutability, imperfect capital mobility, rational expectations, dynamic. • Overshooting model - Empirical evidence • Methods : multivariate lagged regressions • Mixed evidence : some support of PPP in the long-run, some evidence of overshooting in the short-run. • Some support from recent tests.

45. Portfolio approach • Consider 3 assets that investors hold and diversify: • M : Money • B : domestic bonds • F : foreign bonds • Well-defined asset-demand function: • Function of expected rate of return (on both the asset and its various substitutes) • Expected rate of return of foreign assets : defined as i* + expected rate of depreciation of domestic currency. • Function of wealth : implies that changes in price of the assets, and changes in S, will affect assets demand. • Equilibrium is reached when current account of BOP is in equilibrium, and agents do not change their assets in portfolio.

46. Portfolio approach • Portfolio models - Empirical evidence • Difficult to test due to important data problems • Good supporting evidence for the tests run • But bad performance at forecasting (in particular, it does not outperform the random walk) • Econometrical problems could explain this failure, like poor data and poorly specified dynamics.

47. “News” approach • Testing models - News approach • Try to distinguish between expected / unexpected components of exchange rates determinants • Models sensitive to the way news are constructed, and to the choice of the type of news • Poor empirical performance -> research question : what type of news is important to influence expectations on exchange rates?

48. Misalignments • Attempts to explain misalignments of FX rates • Misalignment = departure of exchange rate from its long-run equilibrium • Two types of explanations : • Rational bubbles • Heterogenous expectations

49. Misalignments • Rational bubbles : • Still assuming rational behaviour of markets participants. • Pt = discounted cash-flows + Bt • Bt = E(Bt+1) /(1+r) = bubble component • Bt+1 = (1+r) Bt + Zt • Bubble has a probability of bursting at each period, but grows at an expected rate of r if investors are risk neutral. • Problems • Testing for evidence : joint hypothesis of bubble existence and of the model of FX determination. • Does not explain starts and ends of a bubble dynamic.

50. Misalignments • Heterogeneous expectations : • Wide dispersion of opinions observed, in particular for longer maturities • Model of two groups of forecasters (Frankel & Froot, 1987): • Chartists : extrapolate past experience • Fundamentalists : using Dornbush’s overshooting model • Portfolio managers use a weighted average of these two forecasts, and update the weights according to who is doing better. • Broad empirical support : explained the rise and fall of the dollar in early 1980’s. Questionnaires among forecasters supported the approach.