International Finance Ivar Bredesen Associate Professor South-Western/Thomson Learning © 2003

Course contents The course is divided into four parts: The International Financial Environment Exchange Rate Behaviour Exchange Rate Risk Management Workload – 10 ECTS 8 course work 2 assignments

Required Reading

Required Reading Jeff Madura: International Financial Management, 7th ed. Excellent intermediate level textbook in international finance Textbooks home page http://www.swcollege.com/finance/madura/ifm7e/ifm7e.html

Part I The International Financial Environment Multinational Corporation (MNC) Foreign Exchange Markets Dividend Remittance & Financing Exporting & Importing Investing & Financing Product Markets Subsidiaries International Financial Markets

What’s Special about “International” Finance? Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set

What’s Special about “International” Finance? Foreign Exchange Risk The risk that foreign currency profits may evaporate in home currency terms due to unanticipated unfavorable exchange rate movements. Suppose $1 = ¥100 and you buy 10 shares of Toyota for ¥100,000 (i.e. $100 per share = ¥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. Your $1,000 investment is only worth $916.67

Exposure to International Risk 2000 2001 U.S. Firm’s Cost of Obtaining £100,000

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. Statoil has invested 43.3 billion NOK in countries like Venezuela, Angola, Algerie, Iran, Aserbajdsjan

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

The Example of Nestlé’s Market Imperfection Nestlé used to issue two different classes of common stock bearer shares and registered shares. Foreigners were only allowed to buy bearer shares. Swiss citizens could buy registered shares. The bearer stock was more expensive. On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares.

Nestlé’s Foreign Ownership Restrictions 12,000 10,000 8,000 6,000 4,000 2,000 11 20 31 9 18 24 Bearer share SF Registered share Source: Financial Times, November 26, 1988 p.1. Adapted with permission.

The Example of Nestlé’s Market Imperfection Following this, the price spread between the two types of shares narrowed dramatically. This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders. Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates both the importance of considering market imperfections and the peril of political risk.

What’s Special about “International” Finance? Expanded Opportunity Set It doesn’t make sense to play in only one corner of the sandbox. True for corporations as well as individual investors.

Goals for International Financial Management The focus of the text is to equip the reader with the “intellectual toolbox” of an effective global manager—but what goal should this effective global manager be working toward? Maximization of shareholder wealth? or Other Goals?

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?

Other Goals In other countries shareholders are viewed as merely one among many “stakeholders” of the firm including: Employees Suppliers Customers In Japan, managers have typically sought to maximize the value of the keiretsu—a family of firms to which the individual firms belongs.

Other Goals As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. These calamities have painfully reinforced the importance of corporate governance i.e. the financial and legal framework for regulating the relationship between a firm’s management and its shareholders.

Conflicts Against the MNC Goal For corporations with shareholders who differ from their managers, a conflict of goals can exist - the agency problem. Agency costs are normally larger for MNCs than for purely domestic firms. The sheer size of the MNC. The scattering of distant subsidiaries. The culture of foreign managers. Subsidiary value versus overall MNC value.

The Agency Problem at Enron Enron had about 3,500 subsidiaries and affiliates Many of these were run and partly owned by Enron executives. In retrospect, conflict of interest should have been an obvious concern. The partnerships did hundreds of millions of dollars of transactions with Enron itself, in some cases buying assets from the company or selling assets to it. The problem is this: Where did the executives' loyalties lie? Are they trying to negotiate the best deal for the company that employs them and the shareholders who own the company, or the best deal for the partnership where they had an ownership stake?

Globalization of the World Economy: Recent Trends Emergence of Globalized Financial Markets Advent of the Euro Trade Liberalization and Economic Integration Privatization

Emergence of Globalized Financial Markets Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transactions costs, which has led to: Financial Innovations, such as Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds

Advent of the Euro A momentous event in the history of world financial systems. Currently more than 300 million Europeans in 12 countries are using the common currency on a daily basis. By 2004, up to 10 more countries may join the European Union and adopt the euro. The “transaction domain” of the euro may become larger than the U.S. dollar’s in the near future.

Value of the Euro in U.S. Dollars

Economic Integration Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a sea change in the attitudes of many of the world’s governments who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry.

Multinational Corporations 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.

Top 10 MNCs 1 General Electric United States 2 ExxonMobile Corporation 3 Royal Dutch/Shell Group Netherlands/ UK 4 General Motors 5 Ford Motor Company 6 Toyota Motor Corporation Japan 7 DaimlerChrysler AG Germany 8 TotalFina SA France 9 IBM 10 BP United Kingdom

Theories of International Business Why are firms motivated to expand their business internationally? Theory of Comparative Advantage Specialization by countries can increase production efficiency. Imperfect Markets Theory The markets for the various resources used in production are “imperfect.”

Theories of International Business Why are firms motivated to expand their business internationally? Product Cycle Theory As a firm matures, it may recognize additional opportunities outside its home country.

The International Product Life Cycle  Firm creates product to accommodate local demand.  Firm exports product to accommodate foreign demand.  Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs. a. Firm differentiates product from competitors and/or expands product line in foreign country. b. Firm’s foreign business declines as its competitive advantages are eliminated. or

Valuation Model for an MNC Domestic Model E (CF$,t ) = expected cash flows to be received at the end of period t n = the number of periods into the future in which cash flows are received k = the required rate of return by investors

Valuation Model for an MNC Valuing International Cash Flows 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

Valuation Model for an MNC An MNC’s financial decisions include how much business to conduct in each country and how much financing to obtain in each currency. Its financial decisions determine its exposure to the international environment.

Valuation Model for an MNC Impact of New International Opportunities on an MNC’s Value Exchange Rate Risk Political Risk Exposure to Foreign Economies

How Chapters Relate to Valuation Background on International Financial Markets (Chapters 2-5) Exchange Rate Behavior (Chapters 6-8) Long-Term Investment and Financing Decisions (Chapters 13-18) Short-Term Investment and Financing Decisions (Chapters 19-21) Exchange Rate Risk Management (Chapters 9-12) Risk and Return of MNC Value and Stock Price of MNC