International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael Dimond School of Business Administration Introduction What this class will cover How do I get an A in this class? Relevance Tools & resources Schedule

Michael Dimond School of Business Administration Multinational Corporations What: Not just an international business Has parent company located in a “home country” Has production and distribution facilities in multiple countries Typically at least five or six foreign subsidiaries Who: Examples of MNCs Nestlé, GE, Shell Why: Three main objectives Seeking markets Minimizing costs Access raw materials How: MNCs develop and expand over time Exporting (and/or Licensing) Sales Subsidiary Development of distribution system Overseas production

Michael Dimond School of Business Administration Exporting Minimal cost and risks Low profits Get to know the market

Michael Dimond School of Business Administration Sales Subsidiary Local office Greater customer service Increased communication & insight

Michael Dimond School of Business Administration Development of a Distribution System New service facilities set up Create a warehouse system Marketing activities within a company’s own control

Michael Dimond School of Business Administration Overseas Production Realize full sales potential Keep abreast of market developments Fill orders faster Greatest risk to the company with greatest potential for profit

Michael Dimond School of Business Administration Licensing Alternative to setting up local production Less risk than setting up local production Relatively lower cash flow Faster market entry time Maintaining quality standards may be a problem

Michael Dimond School of Business Administration Example of Multinational Development

Michael Dimond School of Business Administration Important Concepts in International Finance Exchange rates & parity Market efficiency Arbitrage Risk, return & diversification In addition, international finance encompasses all of the “ordinary” skills of domestic financial management, but we have to consider them with a different sensibility. DCF analysis Capital budgeting Strategic & financial planning Compliance & governance

Michael Dimond School of Business Administration Market Efficiency & Exchange Rates The Efficient Market Hypothesis (EMH) Efficiency means prices come into equilibrium An exchange rate is the “price” of one unit of a foreign currency expressed as a certain price in local currency. For example: $0.99/€ means the euro is worth $0.99 in the United States The exchange rate is based on the demand for foreign currency by another economy The demand for currency is driven by the demand for a foreign country’s goods & services Buyers must convert their spending power into foreign currency to make purchases

Michael Dimond School of Business Administration Equilibrium is based on supply & demand At a higher exchange rate, would American demand more euros to make purchases or fewer? Would Germans demand more dollars or fewer?

Michael Dimond School of Business Administration How Exchange Rates Change Increased demand for currency as more foreign goods are demanded, more of the foreign currency is demand at each possible exchange rate The price of the foreign currency in local currency increases. Home Currency Depreciation happens when the foreign currency’s “price” rises. In other words, the foreign currency’s value has appreciated against the home currency. There are many factors which affect exchange rates, but the three most important are growth in an economy, inflation in an economy and interest rates in an economy. There is a lot of jargon involved in foreign exchange, and the best way to learn this is by solving some simple problems. See: Ch 1-3 Key Computations & Concepts

Michael Dimond School of Business Administration The International Monetary System The international monetary system has evolved from the gold standard to an eclectic currency arrangement In the modern world, there are five basic models for foreign exchange: Free Float (“Clean Float”) Managed Float (“Dirty Float) Target Zone Arrangement Fixed Rate System Hybrid System

Michael Dimond School of Business Administration Trade-offs in Currency Management

Michael Dimond School of Business Administration The Gold Standard The Gold Standard, Countries set par value for their currency in terms of gold This came to be known as the gold standard and gained acceptance in Western Europe in the 1870s The US adopted the gold standard in 1879 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/£ = $4.8665/£

Michael Dimond School of Business Administration The Gold Standard Because governments agreed to buy/sell gold on demand with anyone at its own fixed parity rate, the value of each currency in terms of gold, the exchange rates were therefore fixed Countries had to maintain adequate gold reserves to back its currency’s value in order for regime to function The gold standard worked until the outbreak of WWI, which interrupted trade flows and free movement of gold thus forcing major nations to suspend operation of the gold standard

Michael Dimond School of Business Administration The Gold Standard between 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 The gold standard has a similar function In 1934, the US devalued its currency to $35/oz from $20.67/oz prior to WWI From 1924 to the end of WWII, exchange rates were theoretically determined by each currency's value in terms of gold. During WWII and aftermath, many main currencies lost their convertibility. The US dollar remained the only major trading currency that was convertible

Michael Dimond School of Business Administration Bretton Woods & the IMF Allied powers met in Bretton Woods, NH and created a post- war international monetary system in 1944 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)

Michael Dimond School of Business Administration Ramifications of Bretton Woods Each country established its exchange rate vis-à-vis the US dollar and then calculated the gold par value of their currency Participating countries agreed to try to maintain the currency values within 1% of par by buying or selling foreign or gold reserves Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, up to a 10% devaluation was allowed without formal approval from the IMF

Michael Dimond School of Business Administration Fixed exchange rates, 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

Michael Dimond School of Business Administration The End of Fixed Rates 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

Michael Dimond School of Business Administration The IMF’s Exchange Rate Index of the Dollar

Michael Dimond School of Business Administration Returns on gold (as of 2010) In 1971, President Richard Nixon ended the direct convertibility of the dollar to gold

Michael Dimond School of Business Administration Hedge against inflation? Do you see much correlation between gold and inflation since Nixon ended the direct convertibility of the dollar to gold?

Michael Dimond School of Business Administration Hindsight: Gold vs other investments In 1971, President Richard Nixon ended the direct convertibility of the dollar to gold

Michael Dimond School of Business Administration Notable World Currency Events

Michael Dimond School of Business Administration Notable World Currency Events

Michael Dimond School of Business Administration Notable World Currency Events

Michael Dimond School of Business Administration Notable World Currency Events