1. Corporate Finance MLI28C060 Lecture 1 Monday 12 October 2015

2. Strategic decision-making I: the role of financial management and accounting

3. Defining Strategic Management Strategic management is used synonymously with the term strategic planning. Sometimes the term strategic management is used to refer to strategy formulation, implementation, and evaluation, with strategic planning referring only to strategy formulation.

4. Defining Strategic Management A strategic plan is a company’s game plan. A strategic plan results from tough managerial choices among numerous good alternatives, and it signals commitment to specific markets, policies, procedures, and operations.

5. Stages of Strategic Management Strategy formulation Strategy implementation Strategy evaluation

6. Strategy Formulation Deciding what new businesses to enter, What businesses to abandon, How to allocate resources, Whether to expand operations or diversify, Whether to enter international markets, Whether to merge or form a joint venture, How to avoid a hostile takeover.

7. Key Terms in Strategic Management Competitive advantage – anything that a firm does especially well compared to rival firms Strategists – the individuals who are most responsible for the success or failure of an organization

8. Some Opportunities and Threats Computer hacker problems are increasing. Intense price competition is plaguing most firms. Unemployment and underemployment rates remain high. Interest rates are rising. Product life cycles are becoming shorter. State and local governments are financially weak.

9. Key Terms in Strategic Management Objectives – specific results that an organization seeks to achieve in pursuing its basic mission – long-term means more than one year – should be challenging, measurable, consistent, reasonable, and clear

10. Key Terms in Strategic Management Strategies – the means by which long-term objectives will be achieved – may include geographic expansion, diversification, acquisition, product development, market penetration, retrenchment, divestiture, liquidation, and joint ventures

11. Types of national currency regime

12. Foreign exchange I: FX markets, their structure, simple trading techniques Structure: - Types of national currency regime - Implications arising from national choice of fixed, floating or intermediate regimes - Exchange rate parity arrangements Reading: Ghosh, A. R., Gulde, A-M., Wolf, H. C., de Haan, J., & Pagano, M. (2000). Currency Boards: More than a Quick Fix? Economic Policy, 15 (31), 269-335 Bennett, A. G. G. (1993). The operation of the Estonian currency board. Staff Papers - International Monetary Fund, 40 (2), 451-470 LeClair, M. S. (2007). Currency regimes and currency crises: What about cocoa money? Journal of International Financial Markets, Institutions and Money, 17, 42–57

13. What are countries doing? 1.Classification of exchange rate regimes 2.De jure vs. De facto What should countries be doing? 3.Advantages of fixed rates 4.Advantages of floating rates 5.How should the choice be made? 1.Performance by category 2.Traditional criteria for choosing: OCA framework 3.1990s criteria to suit a country for institutionally fixed rate 4.Financial development 5.External shocks: Commodity price volatility. Addenda: Attempts to classify countries’ regimes, & performance The corners hypothesis

14. 1. Classification of exchange rate regime Continuum from flexible to rigid FLEXIBLE CORNER 1) Free float2) Managed float INTERMEDIATE REGIMES 3) Target zone/band4) Basket peg 5) Crawling peg6) Adjustable peg FIXED CORNER 7) Currency board8) Dollarization 9) Monetary union

15. Bottom line on classifying exchange rate regimes It is genuinely difficult to classify most countries’ de facto regimes: intermediate regimes that change over time. Need techniques – that allow for intermediate regimes (managed floating and basket anchors) – and that allow the parameters to change over time.

16. Intermediate regimes target zone (band) Krugman-ERM type (with nominal anchor) Bergsten-Williamson type (FEER adjusted automatically) basket peg (weights can be either transparent or secret) crawling peg pre-announced (e.g., tablita) indexed (to fix real exchange rate) adjustable peg (escape clause, e.g., contingent on terms of trade or reserve loss)

17. Many countries that say they float, in fact intervene heavily in the foreign exchange market. Many countries that say they fix, in fact devalue when trouble arises. Many countries that say they target a basket of major currencies in fact fiddle with the weights. 2. De jure regime  de facto as is by now well-known

18. Implications arising from national choice of fixed, floating or intermediate regimes

19. 3. Advantages of fixed rates 1)Encourage trade <= lower exchange risk. In theory, can hedge risk. But costs of hedging: missing markets, transactions costs, and risk premia. Empirical: Exchange rate volatility ↑ => trade ↓ ? Time-series evidence showed little effect. But more in: - Cross-section evidence, especially small & less developed countries. - Borders, e.g., Canada-US: McCallum-Helliwell (1995-98 ); Engel-Rogers (1996). - Currency unions: Rose (2000).

20. Advantages of fixed rates, cont. 2) Encourage investment <= cut currency premium out of interest rates 3) Provide nominal anchor for monetary policy By anchoring inflation expectations, achieve lower inflation for same Y. But which anchor? Exchange rate target vs. Alternatives 4) Avoid competitive depreciation 5) Avoid speculative bubbles that afflict floating. (If variability were all from fundamental real exchange rate risk, and no bubbles, then fixing the nominal exchange rate would mean it would just pop up in prices instead.)

21. 4. Advantages of floating rates 1. Monetary independence 2. Automatic adjustment to trade shocks 3. Central bank retains seignorage 4. Central bank retains Lender of Last Resort capability, for rescuing banks 5. Avoiding crashes that hit pegged rates, particularly if origin of speculative attacks is multiple equilibria, not fundamentals.

22. 5. Which dominate: advantages of fixing or advantages of floating? Performance by category is inconclusive. To over-simplify 3 important studies (see Addendum I): – Ghosh, Gulde & Wolf: “hard pegs work best” – Sturzenegger & Levy-Yeyati: “floats are best” – Reinhart-Rogoff: “limited flexibility performs best” Why the different answers? – The de facto schemes do not correspond to each other. – A country’s circumstances determine the appropriate regime.

23. Which dominate: advantages of fixing or advantages of floating? Answer depends on circumstances: No one exchange rate regime is right for all countries or all times. Traditional criteria for choosing - Optimum Currency Area. Focus is on trade and stabilization of business cycle. 1990s criteria for choosing – Focus is on financial markets and stabilization of speculation.

24. Optimum Currency Area Theory (OCA) Broad definition: An optimum currency area is a region that should have its own currency and own monetary policy. This definition can be given more content: An OCA can be defined as: a region that is neither so small and open that it would be better off pegging its currency to a neighbor, nor so large that it would be better off splitting into sub-regions with different currencies

25. Optimum Currency Area criteria for fixing exchange rate: Small size and openness – because then advantages of fixing are large. Symmetry of shocks – because then giving up monetary independence is a small loss. Labor mobility – because then it is possible to adjust to shocks even without ability to expand money, cut interest rates or devalue. Fiscal transfers in a federal system – because then consumption is cushioned in a downturn.

26. New popularity in 1990s of institutionally-fixed corner currency boards (e.g., Hong Kong, 1983- ; Lithuania, 1994- ; Argentina, 1991-2001; Bulgaria, 1997- ; Estonia 1992- ; Bosnia, 1998- ; …) dollarization ( e.g, Panama, El Salvador, Ecuador; or euro-ization: Montenegro ) monetary union ( e.g., EMU, 1999)

27. Definition: A currency board is a monetary institution that only issues currency that is fully backed by foreign assets. Its principal attributes include the following: An exchange rate that is fixed not just by policy, but by law. A reserve requirement stipulating that each dollar’s work of domestic currency is backed by a dollar’s worth of foreign reserves. A self-correcting balance of payments mechanism, in which a payments deficit automatically contracts the money supply, resulting in a contraction of spending. Currency boards

28. 1990’s criteria for the firm-fix corner suiting candidates for currency boards or union (e.g., Calvo) Regarding credibility: a desperate need to import monetary stability, due to: history of hyperinflation, absence of credible public institutions, location in a dangerous neighborhood, or large exposure to nervous international investors a desire for close integration with a particular neighbor or trading partner. Regarding other “initial conditions”: an already-high level of private dollarization high pass-through to import prices access to an adequate level of reserves the rule of law.

29. Two additional considerations, particularly relevant to developing countries (i) Level of financial development (ii) Supply shocks, especially: – External terms of trade shocks and the proposal for Product Price Targeting PPT

30. (i) Level of financial development Aghion, Bacchetta, Ranciere & Rogoff (2005) – Fixed rates are better for countries at low levels of financial development: because markets are thin. – When financial markets develop, exchange flexibility becomes more attractive.

31. (ii) External Shocks An old wisdom regarding the source of shocks: – Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); – floating rates work best if shocks tend to be real shocks (especially external terms of trade). One case of supply shocks: natural disasters – R.Ramcharan (2007) finds support. Most common case of real shocks: trade

32. Terms-of-trade variability returns Prices of crude oil and other agricultural & mineral commodities hit record highs in 2008, and again in 2011. => Favorable terms of trade shocks for some (oil producers, Africa, Chile, etc.); => Unfavorable terms of trade shock for others (oil importers like Japan, Korea). Textbook theory says a country where trade shocks dominate should accommodate by floating.

33. IMF classification Of 185 Fund members, Have given up own currencies: – Euro-zone: – CFA Franc Zone: – E.Caribbean CA – “dollarized” Currency boards: Intermediate regimes: – pegs to a single currency – pegs to a composite – crawling pegs – horizontal bands – crawling bands – managed floats “independent floaters”: (end-2004 “de facto”) 41 12 14 6 9 7 104 33 8 6 5 1 51 35