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Why is it important to study international financial management?
We are now living in a world where all he major economic functions, i.e. consumption, production, and investment, are highly globalised. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a situation that existed only a few decades ago, when much of financial education ignored the international aspects, a practice that has become untenable since then.
How is international financial management different from domestic financial management?
International financial management possesses three traits that domestic financial management does not: foreign exchange risk (exists whenever you have to deal with more than one currency) and political risk (when your capital is tied up in a foreign country you are at the mercy of the political situation in the foreign country), market imperfections (When governments impose import and export tariffs, differential tax treatments etc, the free market is constrained) and an expanded opportunity set (provides additional opportunities for investors to diversify, including the ability to diversify away specific country risk).
Discuss the three major trends that have prevailed in international business during the last two decades..
There has been the emergence of globalised financial markets, brought about through the deregulation of financial markets, advances in technology and financial innovations. There has also been the emergence of the euro as a global currency, which was a momentous event in the history of world financial systems. There has been a trend in the changing attitudes of many of the world’s governments, to one have has abandoned mercantilist views and embraced the power of free trade to ensure prosperity for their nations. This has resulted in the General Agreement on Tariffs and Trade (GATT), one of many examples of the liberalisation of protectionist legislation which has reduced many barriers to trade. Finally, a major trend of the last two decades has been increasing rate at which state-owned businesses are being privatised, particularly due to the fall of communism.
In 1995, a working group of French chief executive officers was set up by the Confederation of French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French corporate governance structure. The group reported the following, among other things “The board of directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company, whose interests should be clearly distinguished from those of its shareholders, employees, creditors, suppliers and clients but still equated with their general common interest, which is to safeguard the prosperity and continuity of the company”. Evaluate the above recommendation of the working group.
- The recommendations of the French working group clearly show that shareholder wealth maximization is not a universally accepted goal of corporate management, especially outside the United States and possibly a few other Anglo-Saxon countries including the United Kingdom and Canada. To some extent, this may reflect the fact that share ownership is not wide spread in most other countries. In France, about 15% of households own shares.
- These things are all interlinked, which is not acknowledged by the working group. If the board of directors did aim to maximise share values, they would need to ensure the prosperity and continuity of the company, as the share value is only the value of expected future returns (thereby implying expected future prosperity and continuity).
How does the instantaneous access to information via the internet affect the nature and workings of financial markets?
Ready access to international information helps integrate financial markets, dismantling barriers to international invetment and financing. Integration, however, may help a financial shock in one market to be transmitted to other markets.
Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.
- The adjustment mechanism under the gold standard is regerred to as the price-specie-flow mechanism, expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be correct by a counter-flow of gold.
- Suppose that the US imports more from the UK that it exports (net flow of imports). Under the classical gold standard, gold, which is the only means of international payments, will flow from the US to the UK. As a result, the US will experience a decrease in money supply, and the UK will experience an increase. This means that the price level will tend to fall in the US and rise in the UK. Consequently, the US products become more competitive in the export market, while IK products become less competitive. This change will improve US balance of payments and at the same time hurt the UK balance of payments, eventually eliminating the initial balance of payments disequilibrium.
Supppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exhcnage rate should be two francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?
Suppose that you need to by 6 pounds using French francs. If you buy 6 pounds directly in the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of fold for 12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The arbitrage profit will be 1.2 francs. So far, we have assumed that shipping costs do not exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.
Discuss the advantages and disadvantages of the gold standard.
- The advantages include:
- Limits on inflation (stopping it from getting very high), since the supply of gold is restricted.
- Correction of balance of payments disequilibrium though cross-border flows of gold.
- The disadvantages include:
- Potential for deflationary pressure on the world economy due to the restricted supply of gold.
- No mechanism of the gold standard to 'enforce the rules of the game', so countries may pursue economic policies (like de-monetisation of gold) that are incompatible with the gold standard.
What were the main objectives of the Bretton Woods system?
It was designed to maintain stable exchange rates and economise on gold, and resulted in the creation of the IMF and the World Bank.
Explain the arrangements and workings of the European Monetary System (EMS)
- EMS was launched in 1979 in order to:
- Establish a zone of monetary stability in Europe
- Coordinate exchange rate policies against the non-EMS currencies, and
- Pave the way for the eventual European monetary union.
- The main instruments of EMS are the European Currency Unit (ECU) and the Exchange Rate Mechanism (ERM):
- Like SDR, the ECU is a basket currency constructed as a weighted average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the procedure by which EMS member countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first computed by defining the par values of EMS currencies in terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much as the maximum allowable deviation, the country has to adjust its policies to maintain its par values relative to other currencies. EMS achieved a complete monetary union in 1999 when the common European currency, the euro, was adopted.
In an integrated world financial market, a financial crisis in a country can be quickly transmitted to other countries, causing a global crisis. Wat kind of measures would you propose to prevent the recurrance of an Asia-type crisis?
- 1) Countries must first strengthen their domestic financial system before liberalising their financial markets. This may involve strengthening the countries financial sector regulation and supervision. Countries should depend more on domestic savings and long-foreign invetments, rather than short-term portfolio capital.Banks should be encouraged to lend solely on economic merit rather than political considerations.
- 2) There should be a multinational safety net to safeguard the world financial system from the Asia-type crisis
- 3) International institutions like the IMF and the World Bank should monitor problematic countries more closely and provide timely advice to those countries. Countries should be required to fully disclose the economic and financial information so that devaluation surprises can be prevented.
Define balance of payments
The balance of payments can be defined as the statistical record of a country's international transactions over a certain period of time presented in the form of double-entry bookkeeping. Any transaction resulting in a receipt from foreigners is recorded as a credit, with a positive sign, whereas any transaction resulting in a payment to foreigners is recorded as a debit, with a minus sign.
The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous US current account deficits?
- The current account deficits of the US may be attributable to:
- The strong dollar and undervalued currencies of trading partners such as China
- High consumption and lwo savings in the US and
- Weak competitiveness of US industries.
- If US deficits continue, the dollar may eventually depreciate substantially and the confidence in the dollar may suffer.
In contrast to the United States, Japan has realised continuous current account surpluses.What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses?
- Japan's continuous current account surpluses may have reflected a weak Yen and high competitiveness of Japanese industries. Massive capital exports by Japan prevented the Yen from appreciatingmore than it did. At the same time, foreigners' exports to Japan were hampered by the closed nature of Japanese markets.
- Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by the mercantilist policies.
Explain how a country can run an overall balance of payments deficit or surplus
A country can run an overall balance of payments deficit or surplus by engaging in the official researve transactions. For example, an overall balance of payments deficit can be supported by drawing down the central bank's reserve holdings. Likewise, and overall balance of payments surplus can be absorbed by adding to the central bank's reserve holdings.
Explain how to compute the overall balance and discuss its significance
The overall balance is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall balance is significant becaise it indicates a country's international payment gap that must be financed by the government's official reserve transactions.
Since the early 1980s, foreign portfolio investors have purchased a significiant portion of US treasury bond issues. Discuss the short-term and long-term effects of foreigners' portfolio investment on the US balance of payments.
As foreigners purhcase US Treasury bonds, US balance of payments will improve in the short run. But in the long run, US balance of payments may deteriorate because the US should pay interests and principals to foreigners. If foreign funds are used productively and contributes to the competitiveness of US industries, however, US balance of payments may improve in the long run.
Describe the balance of payments identity and discuss its implications under the fixed and flexible exchange rate regimes.
When the balance-of-payments accounts are recorded correctly, the balance of payments identity is BCA (balance on the current account) + BKA (balance on the capital account) +BRA (balance on the reserves account) = 0. The equation indicates that a country can run a balance-of-payments surplus or deficit by increasing or decreasing its official reserves. Under the fixed exchange rate regime, countries maintain official reserves that allow them to have balance-of-payments disequilibrium, that is where BCA + BKA does not equal 0, without adjusting the exchange rate. Under the fixed exchange rate regime, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the office reserves (BCA + BKA = -BRA). For example, if a country runs a deficit on the overall balance, that is, BCA + BKA is negative, the central bank of the country can supply foreign exchanges out of its reserve holdings. But if the deficit persists, the central bank will eventually run out of its reserves, and the country may be forced to devaluate its currency.
A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CD1.3436-CD1.3441. What is implied about the trader's beliefs by his prices?
The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars by standing willing to buy $ at only CD1.3435/$1.00 (As a client, you will choose to sell $ to the rest of the market for a higher price) and offering to sell from inventory at the slightly lower than market price of CD1.3440/$1.00 (As a client, you are attracted to the lower buying price offered by this trader. As a result, you buy $ from this trader using the CD; the trader ends up with more CD). The future appreciation of the CD will provide an opportunity to make profit on the CD inventory.
Over the past five years, the exchange rate between the British pound and the US dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the US?
The value of the British pound in US dollars has gone from about 1.90 to about 1.45. The British pound has depreciated relative to the dollar.Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct.
What is meant by a currency trading at a discount or at a premium in the forward market?
The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price.
Give a full definition of arbitrage
Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.
Discuss the implications of the interest rate parity for the exchange rate determination.
Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as S = [(1 + I_£)/(1 + I_$)]E[S_(t+1)|I_t]. The exchange rate is thus determined by the relative interest rates, and teh expected future spot rate, conditional on all the available information, I_t, as of the present time. One can thus say that expectation is self-fulfilling. Since the information set will be continuously updated as news hits the market, the exchange rate will exhibit a highly dynamic, random behaviour.
Explain the conditions under which the forward excange rate will be an unbiased predictor of the future spot exchange rate.
- The forward exchange rate will be an unbiased predictor of the future spot rate if:
- The risk premium is insignificant and
- Foreign exchange markets are informationally efficient.
Discuss the implications of the deviations from the purchasing power parity for countries competitive positions in the world market.
If exchange rate changes satisfy purchasing power parity, competitive positions of countries will remain unaffected following exchange rate chages. Otherwise, exchange rate changes will affecte relative competitiveness of countries. If a country's currency appreciates by more than is warranted by purchasing power parity, that will hurt the country's competitive position in the world market. It the currency depreciates, the country's position will stengthen.
Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding?
This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in teh current market rates, it would be difficult to beat the market.
Explain the following conepts of purchasing power parity:
- The law of one price
- Absolute purchasing power parity
- Relative purchasing power parity
- The law of one price: refers to the international arbitrage condition for the standard consumption basket. The law of one price requires that the consumption basket should be selling for the same price in a given currency across countries.
- Absolute purchasing power parity: holds that the price level in a country is equal to the price level in another country times the excange rate between the two countries.
- Relative purchasing power parity: holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.
How would you define transaction exposure? How is it diffeent from economic exposure?
Transaction exposure is the sensitivity of realise domestic currency values of the firm's contractual case flows denominated in foreign curencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and short-term.
How would you define economic exposure to exchange risk?
Economic exposure can be defined as the possibility that the firm's cash flows and thus its market value may be affected by the unexpected exchange rate changes
Discuss the determinants of operating exposure
The main determinants of a firm's operating exposure are (i) the structure of the markets in which the firm sources its inputs, such as labour and matierials, an sells its roducts, and (ii) the firm's ability to mmitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.
What is the difference between the Euronote market and the Eurocommercial paper market?
- Euronotes are short-term notes underwritten by a group of international investment or commercial banks called a 'facility'. A client-borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a discount from vace value, and pay back the full face value at maturity. Euronotes typically have maturities of from three to six months.
- Eurocommercial paper is an unsecured short-term promissory note issued by a corporation or a bank and placed directly with the investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from face value. Maturities typically range from one to six months.
Discuss the regulatory and macroeconomic factors that contributed to the credit crunch of 2007-2008.
- The origin of the credit crunch can be traced back to three key contributing factors: liberalisation of banking and securities regulation, a global savings glut, and the low interest rate environment created by the Federal Reserve Bank in the early part of the decade.
- The US Glass-Steagall Act of 1933 mandated a seperation of commercial banking from other financial services firms - such as securities, insurance, and real estate. The repeal of Glass-Steagall caused a blurring of the functioning of commercial banks, investment banks, insurance companies, and real estate mortgage banking firms. Since the repeal of Glass-Steagall, commercial banks begain engaging in risky financial service activities that they previously would not have and which contributed to the credit crunch.
- The Commodity Futures Trading Commission (CFTC) was created in 1974 to oversee futures trading to guard against price manipulation, prevent fraud among market participants, and to ensure the soundness of the exchanges. Credit default swaps (CDSs), a type of OTC credit derivative security, were not regulated by the CFTC. The CDS market grew from virtulally nothing a half dozen years ago to a $58 trillion market that went largely unregulated and unknown. CDSs have played a prominant role in the credit crunch.
- In the years leading up to the crisis, the world was awash with liquidity, much of it demoninated inUS dollars, awaiting investment. As a result, the United States was able to aintain domestic investment at a rate that otherwise would have required higher domestic savings (or reduced consumption) and also found a ready market with central banks for US Treasury and government agency securities, helping keep US interest rates low.
- The fed Funds target rate fell from 6.5% on May 16, 2000 to 1% on June 25, 2003, and stayed below 3% until May 3, 2005. The decrease in the Fed Funds rate was the Fed's response to the financial turmoil created by the fall in stock market prices in 2000 as the high-tech, dot-com, boom came to an end. Low interest rates created the means for first0time homeowners to afford mortgage financing and also created the means for existing homeowners to trade up to more expensive homes. Low interest rate mortgages created an excess demand for homes, driving prices up substantially in most parts of the country, in particular popular residential areas such as California and Florida.
How did the credit crunch become a global financial crisis?
As the credit crunch escalated, many CDOs found themselves stuck with various tranches of MBS debt, especially the highest risk tranches, which they had not yet placed or were unable to place as subprime foreclosure rates around the country escalated. Commercial and investment banks were forced to write down billions of subprime debt. As the U.S. economy slipped into recession, banks also started to set aside billions for credit-card debt and other consumer loans they feared would go bad. The credit rating firms—Moody’s, S&P, and Fitch—lowered their ratings on many CDOs after recognizing that the models they had used to evaluate the risk of the various tranches were mis-specified. Additionally, the credit rating firms downgraded many MBS, especially those containing subprime mortgages, as foreclosures around the country increased. An unsustainable problem arose for bond insurers who sold credit default swap (CDS) contracts and the banks that purchased this credit insurance. As the bond insurers got hit with claims from bank-sponsored SIVs as the MBS debt in their portfolios defaulted, the credit rating agencies required the insurers to put up more collateral with the counterparties who held the other side of the CDSs, which put stress on their capital base and prompted credit-rating downgrades, which in turn triggered more margin calls. If big bond insurers, such as American International Group (AIG) failed, the banks that relied on the insurance protection would be forced to write down even more mortgage-backed debt which would further erode their Tier I Core capital bases. By September 2008, a worldwide flight to quality investments—primarily short term U.S. Treasury Securities—ensued. The demand for safety was so great, at one point in November 2008, the one-month U.S. Treasury bill was yielding only one basis point. The modern day equivalent of a ‘bank run’ was operating in full force and many financial institutions could not survive.
Security returns are found to be less correlated across countries than within a country. Why can this be?
Security returns are less correlated probably because countries are different from each other in terms of industry structure, resource endowments, macroeconomic policies, and have non-synchronous business cycles. Securities from a same country are subject to the same business cycle and macroeconomic policies, thus causing high correlations among their returns.
Explain the concept of the world beta of a security.
The world beta measures the sensitivity of returns to a security to returns to the world market portfolio. It is a measure of the systematic risk of the security in a global setting. Statistically, the world beta can be defined as Cov(Ri, RM)/Var(RM), where Ri and RM are returns to the i-th security and the world market portfolio, respectively.
Explain how exchange rate fluctuations affect the return from a foreign market measured in dollar terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign investment.
It is useful to refer to Equations 15.4 and 15.5 of the text. Exchange rate fluctuations mostly contribute to the risk of foreign investment through its own volatility as well as its covariance with the local market returns. The covariance tends to be positive in most of the cases, implying that exchange rate changes tend to add to exchange risk, rather than offset it. Exchange risk is found to be much more significant in bond investments than in stock investments.
How would you explain the fact that China emerged as one of the most important recipients of FDI in recent years?
China attracted a great deal of FDI recently because foreign firms want to (i) take advantage of inexpensive labor and resources, and also (ii) gain access to the Chinese market that is often not accessible otherwise.
Explain Vernon's product life-cycle theory of FDI. What are the strenths and weaknesses of the theory?
According to the product life-cycle theory, firms undertake FDI at a particular stage in the life-cycle of the products that they initially introduced. When a new product is introduced, the firm chooses to keep production at home, close to customers. But when the product become mature and foreign demands develop, the firm may be induced to start production in foreign countries, especially in low-cost countries, to serve the local markets as well as to export the product back to the home country. As can be inferred from the boxed reading on Singer in the text, the product life-cycle theory can explain historical development of FDI quite well. In recent years, however, the international system of production has become too complicated to be explained neatly by the life-cycle theory. For example, new products are often introduced simultaneously in many countries and production facilities may be located in many countries at the same time.
Why do you think the host country tends to resist cross-border acquisitions, rather than green field investments?
The host country tends to view green field investments as creating new production facilities and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of existing domestic firms, without creating new job opportunities.
Deine country risk. How is it different from political risk?
Country risk is a broader measure of risk than political risk, as the former encompasses political risk, credit risk, and other economic performances.
Daimler, a German carmaker, acquired Chrysler, the third largest U.S. automaker, for $40.5 billion in 1998. But after years of declining profit and labor problem, Daimler sold off Chrysler to the U.S. private equity firm Cerberus for $7.4 billion in 2007. Study the DaimlerChrysler saga and identify the main factors for the failure of this cross-border merger.
Daimler-Chrysler merger failed to produce synergy effect due to the failure to integrate the two companies with different corporate cultures, inability to cut down labor costs due to a strong labor union at Chrysler, and the competitive pressure from Japanese carmakers.
TUTORIAL 2 PROBLEM QUESTION 1
TUTORIAL 3 PROBLEM QUESTION 1
TUTORIAL 3 PROBLEM QUESTION 2
TUTORIAL 4 PROBLEM QUESTION 4
TUTORIAL 4 PROBLEM QUESTION 6
TUTORIAL 4 PROBLEM QUESTION 10
TUTORIAL 4 PROBLEM QUESTION 11
TUTORIAL 4 PROBLEM QUESTION 12
TUTORIAL 5 PROBLEM QUESTION 1
TUTORIAL 5 PROBLEM QUESTION 3
TUTORIAL 5 PROBLEM QUESTION 4
TUTORIAL 6 PROBLEM QUESTION 5
TUTORIAL 6 PROBLEM QUESTION 6
TUTORIAL 6 PROBLEM QUESTION 9
TUTORIAL 6 PROBLEM QUESTION 11
TUTORIAL 8 PROBLEM QUESTION 1
TUTORIAL 8 PROBLEM QUESTION 3
TUTORIAL 8 PROBLEM QUESTION 4
TUTORIAL 9 PROBLEM QUESTION 2
TUTORIAL 9 PROBLEM QUESTION 3
TUTORIAL 10 PROBLEM QUESTION 2
TUTORIAL 10 PROBLEM QUESTION 3
TUTORIAL 10 PROBLEM QUESTION 4
SAMPLE EXAM QUESTION 3
SAMPLE EXAM QUESTION 4
SAMPLE EXAM QUESTION 5
SAMPLE EXAM QUESTION 6
What makes up the exports (and imports) accounts?
It is the sum of merchandise, services and factor income
What is the equation for the balance on current account?
It is the sum of exports, imports and unilateral transfer (both credits and debits)
What is the equation for the balance on capital account?
It is the sum of credits and debits of direct investment, portfolio investment and other investment.
What is the equation for statistical discrepancies?
It is the sum of balance on current account, balance on capital account and overall balance.
How do you calculate a cross rate matrix?
- Use the formula: S(j/k) = S($/k)/S($/j).
- It is IN the currencies in rows (j) and PER the currencies in columns (k).
- If the question is asking you to use the American term quote, you should use the 'in US$' quotes provided in the table.
If a firm in country A asks a bank for a cross rate of currencies A and B quote, how do you calculate what it would be?
- Step 1: Set up the currency algebra right = A/B = (A/C)/(B/C)
- Step 2: Determine Bid A/B = Bid A/Ask B
- Step 3: Determine Ask A/B = Ask A/Bid B
- Step 4: Answer = Step 2/Step 3
What are the rules for converting forward bid-ask quotes to forward points?
- If forward price > spot price = second number > first number = subtract points from spot rate
- If sport price > forward price = first number > second number = add points to spot rate
What is the difference between an American and a European term quotation?
An American is in US$, whereas a European is per US$.
Which exchange rate will eliminate triangular arbitrage?
The implicit cross rate
How do you perform the strategy of triangular arbitrage?
- Step 1: Compute the implicit cross rate, using any two quotes. e.g. A$/SFR = (A$/$)/(SFr/$)
- Step 2: If the implicit cross rate does not equal the quoted cross-rate, triangular arbitrage exists. We want to buy at the LOWER rate and sell at the HIGHER rate.
- Step 3: List transactions to be conducted.
- Buy (divide)3rd currency using A in A/B cross rate.
- Sell (multiply) 3rd currency for B
- Sell (multiply) B for A. Pick which one to start with based on which currency you have to invest with.
- Step 4: Arbitrage profit = final amount - investment amount