International finance introduction

Fred Thompson 5Real and Financial Sectors • Real Sector: Production and sale of goods and services; acquisition and divestiture of capital assets.. Fred Thompson 11Functions of Financial

International Finance

Introduction

Today’s Objectives

• Understand the syllabus and how it works

• Understand my goals for this course (teaching and learning objectives)

• Understand my philosophy of teaching

• Understand the focus of the course

• Understand FOREX transactions and the role of arbitrage.

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Learning Objectives and Philosophy

• I want you to learn how to DO things

– Perform codified practices such as calculating

cross-exchange rates, currency and

intertemporal arbitrage, currency hedging

– Understand when and why to perform them, as

well as how

• Watch, Do, Teach

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Real and Financial Sectors

• Real Sector: Production and sale of goods and services; acquisition and divestiture of capital assets.

• Financial Sector: Transactions in financial assets: currency, bank deposits, bonds, stocks, futures and

options, etc

International Economic

Integration

International economic integration refers to the

extent and strength of real- sector and

financial-sector linkages among national

economies Real-sector linkages occur through

the international transactions in goods and

services while the financial-sector linkages

occur through international transactions in

financial assets.

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The Rise of Multinational Firms

• Changes our definition of comparative Advantage

– Relative value-added product development, design, logistics,

assembly, marketing depends less on national differences and

more on firm-specific competencies and investments, although

these latter reflect national differences in factor endowments

– The range of a nation’s exports is equivalent to the range of its

exports

• Comparative Advantage in a world of

multinationals

– Most cross-border trade involves intermediate products, much of it

takes place within the boundaries of a single firm (a single Barbie

doll is made in 12 countries)

Evolution of the Multinational

Corporation (FDI)

• Raw materials seekers.

• Market seekers.

• Cost minimizers/product enhancers

– Coase firms exist where they reduce transactions (search,

bargaining, monitoring and enforcement costs) and logistics costs,

otherwise transactions would take place through markets They

internalize externalities, economies of scale and scope (which give

rise to non-exhaustibility), thru creation of effective governance

institutions, that would obtain in a world without organizations.

– Some of these potential economies can be obtained by locating

operations where factor costs are lower.

• Flexibility, adaptability, & speed of response

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International Financial Management: Why?

• Financing & investment decisions that maximize value added by firm

• Asset deployment & utilization to increase PV future cash flows

– You must create value first before you can

distribute it

• True of Corp Finance in general, so why study IFM? What makes it different?

International Financial Management: Why?

• Borders, different currencies

• BUT, if financial markets were completely

integrated, different currencies wouldn’t matter

(Of course, if there were no real exchanges, you

wouldn’t need financial markets.) IN NEITHER

CASE WOULD WE BOTHER TO STUDY IFM!

• IFM deserves a special course only because

integration has gone far enough to give it meaning,

but not far enough to make it just like domestic

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Functions of Financial Management:

Acquisition & Investment of Funds

Differences relevant to

international financial

management

• Exchange risks, taxes, multiple

money markets (often w/limited

access to credit, some

w/currency controls), political

risks

• Access to segmented money

markets, shift profits to lower

taxes, reduce risk thru

international diversification of

markets & production sites

Constants relevant to international financial management

– Unsystematic (diversifiable) risk

• Total risk

• You cannot create value with smoke and mirrors

FOREX

Multinational Policymaking

The International Financial

Architecture

International Financial

Architecture

• The international financial architecture is comprised of

the institutions, governmental and non-government

organizations, and the policies that govern activity in the

international monetary and financial markets.

important aspect of the international financial system is the

growth of capital flows among nations.

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Capital Market Liberalization

• Advocates of liberalized capital flows argue that unhindered capital flows allow savings to flow to

their most productive use, resulting in the development of real resources and higher productivity

• Financial market imperfections may result in capital misallocations and financial instability.

Financial Instability and

Financial Crisis

sector is unable to allocate funds to their most

productive use

financial system is no longer able to function A

financial crisis typically involves

– a banking crisis,

– a currency crisis, and

– a foreign debt crisis.

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Capital Flows and Financial Crisis

• International capital flows consists of short-term (primarily portfolio) capital flows, and long-term

(primarily foreign direct investment) flows

• An excessive reliance on portfolio capital can be destabilizing and may contribute to financial crises.

Multilateral Policymaking

international financial crises are:

organization the promotes international monetary policy

cooperation, exchange arrangements, and economic

growth.

• The World Bank: A sister institution that specializes in

making loans to developing nations to promote

development and growth.

– An inconsistency between the exchange rate

and economic fundamentals.

– Speculative attacks.

– Structural moral hazards.

Balance-of-Payments Accounts and Net Financial Flows

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Financial Inflow

• Balance of Payments is a flow account, which consists of the current account

and the capital and financial account

• A flow of capital, real and/or financial, into a country, takes the form of

increased purchases of domestic assets by foreigners and/or reduced holdings

of foreign assets by domestic residents Inflows are recorded as positive, or a positive , or a

credit

credit, in the capital and financial account , in the capital and financial account.

• Each country also has an international balance sheet, which is a stock account

which shows assets and liabilities abroad and foreign assets and liabilities at

home Called the international investment positions accounts in the

U.S (the accumulated stocks of U.S.-owned assets abroad and of

foreign-owned assets in the United States)

• The net change in the international investment positions accounts from the

beginning of one year to the end of the next is the net capital/financial flow for

the year

Exchange and Net Flows

services for other goods and services or for financial

claims (will give rise to a net change in financial claims

if x≠m)

claims for other financial claims (net financial claims are

unchanged)

[ignoring reporting errors and official settlements]

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Balance of Payments Statistics for the

United States, 1966

(Amounts in millions of dollars)

Sources of Foreign Exchange

• Exports of Goods and Services $43,142

Balance on goods, services, remittances,

and pensions +$4065

• Foreign Capital Flow, net $2,532

Balance of all of the above -$1357

• Change in U.S Reserve Assets $568

• Change in Liquid Liabilities of Foreign

Accounts $789

.

Uses of Foreign Exchange

• Imports of Goods and Services $38,063

• Remittances and Pensions $1,015

• U.S Government grants, net $3,444

• U.S private Capital Flow, net $4,298

• Errors and Omissions $210

Source: Federal Reserve Bulletin, April 1969, pp A70-71

The Balance of Payments

Accounting System

International Bookkeeping

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International Transactions Accounts (Balance of Payments)

A quarterly statistical summary of transactions between U.S and foreign residents organized into three

major categories:

– The current account

– The capital account

– The financial account

Balance of Payments

• System of accounts which is a subset of the National Income and Production Accounts

– A double-entry bookkeeping system.

– Debit Entries: Transactions that generate a

payment outflow (e.g., import).

– Credit Entries: Transactions that generate a

payment inflow (e.g., export).

Balance of Payments

• Goods: Exports and imports of tangible items.

• Services: Exports and imports of services, for example:

– Typical business services such as banking and

financial services, insurance, and consulting.

– Tourism

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Balance of Payments

• Income Receipts: Includes items such as

– Investment income on US-owned assets abroad.

– Receipts of income on US direct investment

abroad.

– Government income receipts

Balance of Payments

• Income Payments: Includes items such as

– Investment income on foreign-owned assets in

the United States.

– Payments of income on foreign direct

investment in the United States

– US Government income payments

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Balance of Payments

• Unilateral Transfers: Includes items such as:

– Government grants abroad

– Private remittances

– Private grants abroad

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Balance of Payments

The Financial Sector

modified to bring them more in line with definitions

recommended by the International Monetary Fund.

– The capital account includes capital transfers, such as debt

forgiveness

– The financial account includes transactions for official assets, for

U.S Government assets other than official reserve assets, for

direct investment, for portfolio investment, and for other

investment.

Balance of Payments

The Financial Sector

• The new Capital Account includes items that were previously included in unilateral transfers, such

as:

– Debt forgiveness

– Migrants’ transfers (as they leave the country).

• The new capital account is small for the US (< 0.1 percent of capital flows), but expected to grow.

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Balance of Payments

The Financial Sector

• The Financial Account

– Records international transactions in the

financial sector

– Includes portfolio and foreign direct investment

– Includes changes in banks’ and brokers’ cash

deposits that arise from international

transactions.

Balance of Payments

The Financial Sector

• US-Owned Assets Abroad: Increase or decrease in US ownership of foreign financial assets.

• Foreign-Owned Assets in the US: Increase or decrease in foreign ownership of domestic assets.

• Reserve Assets: Primarily the assets of central banks.

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Balance of Payments

The Financial Sector

• Portfolio Investment: Individual or business purchase of stocks, bond, or other financial assets or

deposits (An income strategy)

• Foreign Direct Investment: Purchase of financial assets that results in a 10 percent or greater

ownership share (A financial control strategy)

Capital and Financial Account

Foreign Official Assets 35,909 Other Foreign Assets 916,521

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The Balance of Payments

The Statistical Discrepancy

Balance on Current Account -435,377

Capital Account, net 680

Net Financial Flows 399,081

Statistical Discrepancy 35,616

International Allocation of

Capital

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Feldstein - Horioka

• Savings and Investment Relation

• Based on a closed economy income condition:

y = c + i + g

• Rearrange as:

y - c - g = i

• In a closed economy, domestic investment is equal to

domestic saving by definition, but is also correlated in

practice, i.e., correlation coefficient is necessarily

close to 1 in value.

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International Flow of Goods,

Services, & Capital

• Domestic Savings and Investment & NFF

National Income (GNY) = Consumption (C) + Savings (S)

National Spending (GNE) = Consumption (C) + Investment (I)

GNY - GNE = S - I GNY - GNE = Exports (x) - Imports (m)

S - I = x - m Net Foreign Investment = x - m

Government Budget Deficits and

GovDeficit/ Surplus

NFF = Private savings surplus - GovDeficit

US Balance of Payments

U.S TRADE AND CURRENT ACCOUNT BALANCESEXPRESSED AS A PERCENTAGE OF GDP

Basic Premise

capital inflows, or it cannot be incurred in the first place

Over 1982-2003, U.S current account deficits have averaged

$183 billion per year.

been transferred to foreign

ownership.

FACT

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Trade and Scale Variables I

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Scale Variables I

U.S monthly GDP: $1 trillion

• Monthly goods and services exports: $130 billion = 13%

• Monthly goods and services imports: $185 billion = 18.5%

• Balancing item: net capital flow: $55 billion = 5.5%

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Scale Variables II

U.S GDP per worker: $84,000 per year

• Exports of $10,900 per year

• Imports of $15,500 per year

Foreign claims on U.S assets now exceed U.S claims on foreign assets by about $2.7

trillion.

– Storing up purchasing power for the future

– Private political risk insurance – Public political risk insurance

International Investments

(market value, end-2003)

U.S foreign investments: $7.9 trn

Foreign investments in U.S.: $10.5 trn

Much of this capital inflow has been portfolio investment.

Some has been direct investment

Foreign Direct Investment

(market value, end-2003)

U.S DI abroad: $2.7 trillion

Foreign DI in U.S.: $2.4 trillion

Net: $0.3 trillion

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Direct Investment Positions

At current market value, $ trillion

U.S Direct Investment Abroad

Foreign Direct Investment in U.S.

US foreign direct investment, 2001

U.K.

18%

Europe 34%

Canada 10%

Asia,P acific

2%

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Foreign direct investment in US, 2001

UK 16%

other Europe 56%