International finance Professor Ivar Bredesen International Finance

Course contents The course is divided into four parts: The International Financial Environment Exchange Rate Behaviour Exchange Rate Risk Management Multinational Capital budgeting Workload – 10 ECTS course work and required assignments International Finance

Required Reading or International Finance

Organization of the Text http://www. cengage. co 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 International Finance

What will we be covering? We will cover the following chapters: 1 -3: Mostly introductory chapters 4: Exchange rate determination 5: Currency derivatives 7: International arbitrage and interest rate parity 8: Inflation, interest rates and exchange rates 9: Forecasting exchange rates International Finance

What will we be covering? Important chapters, continued: 10: Measuring exposure to exchange rate fluctuations 11: Managing transaction exposure 12: Managing economic exposure and translation exposure 14: Multinational capital budgeting Note that we will cover some chapters in more depth than the textbook. It is therefore important to read the lecture notes also. International Finance

Financial Risk Management The field of financial risk management normally contain the following: Interest rate risk Commodity price risk Equity risk Currency risk This course will deal with currency risk We need to know some finance to assess the instruments used to hedge currency risk and some economics to understand exchange rate behaviour International Finance

Norsk Hydro (2004 annual report) International Finance

The IMF’s Nominal Exchange Rate Index of the Dollar International Finance

History of the International Monetary System The Gold Standard, 1875-1916 Countries set par value for their currency in terms of gold Norway joined the Swedish-Danish monetary union on October 16, 1875. New currency “krone” with value based on gold. Link to gold suspended on August 8 1914. Several changes after that The “rules of the game” for the gold standard were simple Example: US$ gold rate was $20.67/oz, the British pound was pegged at £4.2474/oz US$/£ rate calculation is $20.67/£4.2472 = $4.8665/£ International Finance

History of the International Monetary System The Inter-War years and WWII, 1914-1944 During WWI, currencies were allowed to fluctuate over wide ranges in terms of gold and each other, theoretically, supply and demand for imports/exports caused moderate changes in an exchange rate about an equilibrium value Competitive devaluations and “beggar thy neighbour” policies In 1934, the US devalued its currency to $35/oz from $20.67/oz prior to WWI It became clear that the system needs “rules” and a “conductor” International Finance

History of the International Monetary System http://www. youtube Bretton Woods and the IMF, 1944 Allied powers met in Bretton Woods, NH and created a post-war international monetary system The agreement established a US dollar based monetary system and created the IMF and World Bank Under original provisions, all countries fixed their currencies in terms of gold but were not required to exchange their currencies Only the US dollar remained convertible into gold (at $35/oz with Central banks, not individuals) International Finance

Bretton Woods

Stability until 1971 USD/NOK 1945-1988

History of the International Monetary System Fixed exchange rates, 1945-1973 Bretton Woods and IMF worked well post WWII, but diverging fiscal and monetary policies and external shocks caused the system’s demise The US dollar remained the key to the web of exchange rates Heavy capital outflows of dollars became required to meet investors’ and deficit needs and eventually this overhang of dollars held by foreigners created a lack of confidence in the US’ ability to meet its obligations International Finance

History of the International Monetary System http://www. youtube This lack of confidence forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971 Exchange rates of most leading countries were allowed to float in relation to the US dollar By the end of 1971, most of the major trading currencies had appreciated vis-à-vis the US dollar; i.e. the dollar depreciated A year and a half later, the dollar came under attack again and lost 10% of its value By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float By June 1973, the dollar had lost another 10% in value International Finance

Huge problems today… Headlines For Tuesday, November 9, 2010 Tensions over currencies and trade gaps are simmering ahead of a summit of global leaders this week as America's move to flood its sluggish economy with $600 billion of cash triggers alarm in capitals from Berlin to Beijing….Export-reliant nations, many of them poor, fear the US Federal Reserve move will drive more cash into their markets in search of higher returns, driving their currencies even higher and hurting manufacturers that provide jobs and security for fast-growing populations. At the same time, China has maintained tight control over its currency, the yuan, adding to criticism it is kept artificially low and gives Chinese exporters an unfair export advantage….” [Associated Press/Factiva] International Finance

New gold standard? Headlines For Tuesday, November 9, 2010 BBC adds that “…one solution – proposed by World Bank President Robert Zoellick – is to return to a modern version of the gold standard. Unlike the original gold standard… he does not advocate rigidly fixing the value of currencies against the price of gold. Instead, Zoellick suggested that a future system of flexible exchange rates should reference gold – instead of the US dollar – as a common point of valuation. The implication of Zoellick's suggestion is that countries like China would rely much less on buying US dollars, and more on buying gold and other currencies to build up their reserves….” [BBC News] International Finance

Trade imbalances Headlines For Tuesday, November 9, 2010 AFP writes that meanwhile, “…South Korea and the US have floated the idea of a numerical limit on trade surpluses or deficits, with the US proposing four percent of GDP. But the plan for a fixed target ran into strong opposition from China, Germany and other nations. G20 finance ministers last month set no specific targets but pledged to work to reduce excessive current account imbalances and maintain them at ‘sustainable’ levels. Persistently large imbalances, assessed against ‘indicative guidelines’ to be agreed later, would warrant an assessment by the International Monetary Fund….” [Agence France Presse/Factiva] International Finance

Foreign Exchange Markets The FOREX market provides the physical and institutional structure through which The money of one country is exchanged for that of another country The rate of exchange between currencies is determined Foreign exchange transactions are physically completed The FOREX market is extremely competitive and highly efficient International Finance

Transactions in the Interbank Market Transactions within this market can be executed on a spot, forward, or swap basis A spot transaction requires almost immediate delivery of foreign exchange A forward transaction requires delivery of foreign exchange at some future date A swap transaction is the simultaneous exchange of one foreign currency for another International Finance

Outright Forward Transactions This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months Terminology typically used is buying or selling forward A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros International Finance

Swap Transactions A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counterpart A common type of swap is a spot against forward The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure International Finance

Size of the FOREX Market http://www.bis.org/publ/rpfxf10t.pdf The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$4.0 trillion in April 2010, up from 3.2 trillion in 2007 Spot transactions at $1,490 billion/day, up 48 % Outright forward transactions at $475 billion/day Swap transactions at $1,765 billion/day International Finance

Global Foreign Exchange Market Turnover, April 2010 (daily averages, billions of U.S. dollars) International Finance

Turnover by instrument International Finance

Turnover by currency International Finance

International Finance

Top trading centers International Finance

Norway April 2010 (million USD) total, USD, Euro, Yen, GBP, Swiss Francs International Finance

Foreign Exchange Rates & Quotations Direct and Indirect Quotes A direct quote is a home currency price of a unit of a foreign currency NOK 5/$ is a direct quote in Norway An indirect quote measures how much foreign currency you can buy for one unit of your own NOK 0.2/$ is an indirect quote in the Norway, NOK 0.2/$ is a direct quote in the US and an indirect quote in Norway International Finance

Foreign Exchange Rates & Quotations Interbank quotes are given as a bid and ask The bid is the price at which a dealer will buy another currency and the ask or offer is the price at which a dealer will sell another currency This is the bid/ask spread. bid/ask % spread = ask rate – bid rate ask rate Example: ¥118.27 - ¥118.37/$ is the bid/ask for Japanese yen Bid/Ask spread = (118.37 – 118.27)/118.37 = 0.0845 % International Finance

Foreign Exchange Rates & Quotations Forward Quotations can be expressed in several ways We will generally use the actual forward exchange rate – called an outright quote Forward quotes are also quoted in terms of points i.e. how much they differ from the spot rate. A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal The difference between spot rates and forward rates can also be expressed as a % per-annum deviation from the spot rate (premium or discount) International Finance

Foreign Exchange Rates & Quotations Expressing Forward Quotations on a Points Basis The yen is quoted only to two decimal points A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates Example: Bid Ask Outright spot: ¥118.27 ¥118.37 Outright forward: ¥116.84 ¥116.97 Plus points (3 months) -1.43 -1.40 International Finance

Foreign Exchange Rates & Quotations Forward Quotations in Percentage Terms For direct quotes (i.e. quote expressed in home currency terms), the formula is If > 0, the foreign currency is said to be trading with a premium, if < 0 the foreign currency is trading with a discount International Finance

Euro spot and forward Jan 10 - 2011 http://markets. ft International Finance

Foreign Exchange Rates & Quotations Cross Rates Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (MXP) and Japanese yen (¥) are quoted in US dollars Assume the following quotes: Japanese yen ¥110.73/$ Mexican peso MXP 11.4456/$ International Finance

Foreign Exchange Rates & Quotations Cross Rates The Mexican importer can buy one US dollar for 11.4456 Mexican pesos and with that dollar buy ¥110.73; the cross rate would be ¥ 9.6745/MXP MXP11.4456/$ 110.73/$ dollar pesos/US Mexican yen/US Japanese = International Finance

Currency Futures and Options Market A currency futures contract specifies a standard volume of a particular currency to be exchanged on a specific settlement date. Unlike forward contracts however, futures contracts are sold on exchanges. Currency options contracts give the right to buy or sell a specific currency at a specific price within a specific period of time. They are sold on exchanges too. International Finance