2. International Finance Session 1: Introduction Dick Sweeney

3. Introduction What’s different about International Finance? Multiple currencies, exchange rates: $, £, ¥, €, baht, rupiah, yuan, krona, krone, … International financial markets--everywhere and nowhere (London, Tokyo, Bahrain—Chp. 4, on reserve) Multiple governments, laws, languages, cultural environments (e.g., U.S., Indonesia—2 nd half) Exponential complexity –Not 10 x 2, but 10 2

4. Introduction (cont.) Open exchange rate positions are risky What’s the risk-return trade off? Deposit in Euros vs. in USD  S t+1 /S t + i eur,t vs. i usd,t  S t+1 /S t + i eur,t - i usd,t : excess return E  S t+1 /S t + i eur,t - i usd,t : expected excess return E  S t+1 /S t + i eur,t - i usd,t =  t (E R M,t - i usd,t ) E  S t+1 /S t + i eur,t = i usd,t +  t (E R M,t - i usd,t )

5. Introduction (cont.) How to survive the complexity? Ask… What’s the same? Same tools are used Net present value Portfolio analysis (mean-variance analysis) Asset pricing models (one example: CAPM) Option theory Tools are flexible  use them flexibly Primacy of Intuition  experience

6. Comparison of Stocks and Exchange Rates Stocks Exchange Rates Prices look like “random walks” “random walks” Returns are pretty close to random close to random Systematic risk, Non-systematic risk Non-systematic risk

7. Comparison of Stocks and Exchange Rates (cont.) Stocks Exchange Rates Returns depend on betas, risk factors betas, risk factors Average market beta: unity Average market beta: zero Typical stock’s beta: Typical exchange rate’s beta: fluctuates around unity fluctuates around zero Standard deviation: U.S. Standard deviation: USD, stock market, 4.33% to 2.9% to 3.5% per month for 5.77% per month most currencies

8. Exchange-Rate Risk How big is FX risk? –Sigma (  )?  3.3% per month? –Beta (  )? 0.0?  0.10?  0.20? Which risk matters for you? for client? What can you do about risk? Hedge  eliminate risk Portfolio choices (diversification)  reduce risk on average Valuation: How to handle FX risk?

9. What do firms do about risk? Derivatives used by: 59% of large firms, 13% of small firms in U.S.—survey FX derivatives: 76% of derivative users Which FX derivatives? 75% forwards, 50% options Contractual exposure: 86% forwards, 7% options

10. Goals of Course Know the basics about FX markets, how they are organized and work Know the basics of FX risk management Know how to analyze international capital- budgeting problems, or valuation problems Know how to analyze FX problems Know how to choose which tools to use Know how to solve FX problems

11. Topics and Time Allocation: 1

12. Topics and Time Allocation: 2

13. Role of Concepts

14. Analytical Techniques

15. Parity Conditions Parity Conditions: Percent of What You Should Know

16. The Euro: A First Look Born Jan. 1, 1999--rocky 6 years Euro as currency started Jan. 1, 2002 What can be expected? –In concrete, quantitative terms in next month? –In general terms over next several years? Look at history of DEM during float –Large ups and downs Euro looks “normal” compared to history

18. USD/DEM Appreciation Rate