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

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

Required Reading Jeff Madura and Roland Fox: International Financial Management, 1st ed. Excellent intermediate level textbook in international finance Textbooks home page http://www.thomsonlearning.co.uk:8089/madura_fox/

Required Reading

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

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

Norsk Hydro (2004 annual report)

Norsk Hydro 2004

The effects of exchange-rate changes Shifts in ‘forex’ (FOReign EXchange), can impact on various aspects of a firm’s activities Income to be received from abroad The amount actually paid for imports at some future date The valuation of foreign assets and liabilities The long-term viability of foreign operations The acceptability, or otherwise, of an overseas investment project

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

Exchange-rate movements, US$ to £, November 1989–November 2004

Exchange-rate movements, £ to euro, November 1998 to November 2004

Exchange-rate movements, US$ to euro, November 1999 to November 2004 (weekly)

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

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

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.

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

Multinational Corporations The textbook focuses on the operation of a multinational company, meaning a firm that has incorporated on one country and has production and sales operations in other countries. Many small and medium sized companies also have international operations, and the discussion in the textbook is relevant not just for multinationals

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 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