Lecture notes, lectures 1-6 PDF

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- - - - - merged files: FINS 3616 Lecture Notes-Week 1 6Slides(1).pdf - FINS 3616 Lecture Notes-Week 2 6Slides.pdf - FINS 3616 Lecture Notes-Week 3 6Slides.pdf - FINS 3616 Lecture Notes-Week 4 6Slides.pdf - FINS 3616 Lecture Notes-Week 5 6Slides.pdf - FINS 3616 Lecture Notes-Week 6 6Slides(1)....

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FINS3616 International Business Finance

FINS3616 International Business Finance

Dr Bohui Zhang (Week 1-6) 9385 5834 Room: ASB 314 (access from west lobby) Email: [email protected] Consultation: Tue 16:00 – 18:00 (or by appointment)

Dr Jaehoon Lee (Week 7-12) 9385 6013 Room: ASB 365 (access from east lobby) Email: [email protected]. Consultation: Fri 12:00 – 14:00 (or by appointment) 1-1

1-2

Textbook

Assessment

 Required

textbook: - Bekaert, Geert, and Hodrick, Robert, 2012, International Financial Management: International Edition, 2nd ed. Pearson - This book is available from the UNSW bookshop located near the Quadrangle.

 Other

reference: - Butler, Kirt, 2008, Multinational Finance, John Wiley Publishing, 4th Edition.



Tutorials - Attendance - Participation

10% 5% 5%



Mid Session - Week 7 – Saturday (Sep. 14th) - Coverage: Week 1 to 6

30%



Group project

25%



Final Examination - Formal exam period - Coverage: Week 7-12

35%



Total

100%

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1-3

Mid-session Exam 

It includes 45 multiple choice questions.



Closed book



One and a half hours



Details will be discussed in week 6.

Study Tools 

Australian Securities Exchange (http://www.asx.com.au/)



Reserve Bank of Australia (http://www.rba.gov.au/)



World map (http://maps.google.com/)

Bloomberg.com (http://www.bloomberg.com/news/)



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1-6

Australia's top 10 export markets in 2010

Three phases of business Three

broad phases in the evolution of a

firm 1. Introduction of international business finance

- Domestic phase : operations are confined within the boundaries of one country - International trade phase : the firm imports materials or export its product or both - Multinational phase : the firm establishes operations overseas

1-10

The objective of international business finance Y1905

 This

Local business Australian mills

Rio Tinto Y1990

course is concerned with multinational corporations (MNCs)

 It Export Chinese mills

Rio Tinto

takes the perspective of a financial manager in a multinational corporation

 It

Y2001 Foreign operation Rio Tinto

Grasberg Joint Venture, Indonesia

develops framework for evaluating the opportunities, costs, and risks of operating in the world’s markets for goods, services, and financial assets 1-12

The objective of international business finance

Structure of a multinational corporation

 Goals

of an MNC --Maximize shareholder wealth (US, UK, Australia) --Maximize stakeholder wealth (Europe and Asia)  Conflict

of interest between shareholders and managers

Independent board of directors; concentrated ownership; executive compensation; shareholder activism and litigation; hostile takeovers

1-13

1-14

Theoretical support for multinational operations  Theory o off compa comparativ rative ad vantage:

a country should produce and export goods if it can produce with relative efficiency and import goods from other nations which can produce more efficiently.

2. Opportunities of multinational operations

 For

example: -- Australia: mining and agricultural industries -- India: IT industry -- Japan/Germany: manufacturing -- Saudi Arabia: oil-based industries 1-16

How do MNCs enter foreign markets? 

Four methods

--Licensing: gives local firms right to manufacture their products in exchange for fees --Franchising: provides specialized sales or service strategies in exchange for fees. e.g. McDonald --Joint venture: jointly invest and operate a business with a foreign company. --Foreign direct investment: starts a company from scratch

1-18

 Political

risk - The risk that a host government will change the “rules of the game” under which business is conducted. - Due to unexpected political changes within a host country or to the host’s relationship with other governments.

3. Challenges of multinational operations

 Financial

risk - Foreign exchange risk: the risk of an unexpected change in the value of the firm due to an unexpected change in exchange rates - Financial crises

 Cultural

risk is the risk of dealing with an unfamiliar

culture

1-20

Example: -- Political risk The dispute between US and Iranian governments in 1970s --Financial risk July 2008 1 A$= 0.97 US$ November 2008 1A$=0.61 US$ Now 1 A$=0.93 US$

4. MNCs’ international partners

--Culture risk Does everyone around the world like Starbucks coffee? Alcohol in Dubai?



International Banks e.g. BGI, Citibank, ANZ, and Commonwealth

International Institutions --The International Monetary Fund (IMF) --The World Bank --Regional development banks e.g. The Asian Development Bank (ADB) --The World Trade Organization (WTO) --The Organization for Economic Cooperation and Development (OECD) --The Bank for International Settlements (BIS) --The European Union (EU)





Governments

Individual and Institutional Investors e.g. hedge funds, private equity firms, and sovereign wealth funds 

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5. Globalization

Globalization  Definition:

increasing connectivity and integration of countries and corporations and the people within them in terms of their economic, political, and social activities

Recent integration of global markets for goods & services:   

 Implication:

- integration of the markets for goods and services - integration of international financial markets



1960s only 20% of countries were open; By 2000, over 70% of countries were open Free trade agreements: 1995 creation of the World Trade Organization (WTO) 1999 creation of the euro and its adoption by an expanding set of European countries Outsourcing – shifting of non-strategic functions to specialist firms

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International Trade as a Percentage of GDP

WTO members in January 2012 1-28

Recent integration of financial markets: 

Financial market liberalization in both developed and emerging markets in 1980s and 1990s



Increasingly interdependent national financial markets, including cooperative linkages among securities exchanges



Derivative contracts and securitization techniques become more popular

1-29

Balance of payments  The

6. How to record a country’s cross-border business? Can we do it like a firm’s income statement?

balance of payment (BOP)

- records all economic tr transactions ansactions between the residents of the home country and residents of all other countries E.g. According to Australian Bureau of Statistics, the Australian BOP is a systematic record of economic transaction between residents of Australia and residents of the rest of the world.

- measures all financial and economic transactions over a specified period of time time.

1-32

Balance-of-Payments Statistics 

Australia’s balance of payments

Types of accounts and balances: Current account measures purchases of goods/services, interest and dividend receipts and payments, and transfer payments between countries (e.g., gifts or aid) Capital account measures cross-border transactions associated with changes in ownership of assets and liabilities  Regular capital account measures transactions on assets except gold and currencies  Official settlement account measures transactions on gold and currencies

Current account Goods: exports Goods: imports Services: exports Services: imports

2009 1,068 -1,575 502 -370

Receipts from foreign investments 588 Payments on foreign assets in Australia -467 Net unilateral transfers Current account balance

-125 -379

1-33

Balance-of-Payments Statistics Australia’s balance of payments Capital account Regular capital account Australian assets aboard Foreign assets in Australia Financial derivatives Official settlements account Australian reserves assets Foreign official assets Capital account balance

2009 -89 -144 214

 Double-entry

 An

-52 450

accounting system

Each transaction gives rise to a credit (inflows) and a debit (outflows), both of equal value important Balance of Payments identity:

• Current Account + Capital Account = 0

379

1-36

Week 2 Exchange Rate Systems 1. 2. 3. 4.

Exchange Rate Systems History of Exchange Rate Systems The Role of Central Banks The Road to Monetary Integration in Europe

1. Given great demand of cross-border trade and investment, how do we exchange currencies?

1-1

Exchange rate systems 

Pegged or fixed exchange rate systems  In pegged or fixed systems, governments maintain currency values at official exchange rates.  Exchange rate changes are called devaluation (revaluation) when the currency falls (rises).



Floating exchange rate systems  Floating systems allow values to fluctuate according to supply and demand, without direct interference by government authorities.  Exchange rate changes are called depreciation (appreciation) when the currency falls (rises).

1-4

Exchange rate systems around the World 

Pegged or fixed exchange rate systems  Conventional fixed rate like Jordan and Saudi Arabia  Target zones and crawling pegs like China  Currency board like Hong Kong



Floating exchange rate systems  Independently floating like the U.S., Japan, and Australia



No separate legal tender  Adopt the currency of another country. For example, Ecuador and Panama use the US dollar, and Kiribati uses the Australian dollar.

 Managed floating like Argentina and Brazil

1-6

What drives exchange rate in a freely floating system?

Distribution and Trend in exchange rate systems

 Exchange

rates are determined by demand and supply of a currency

 E.g.

if there is excess demand for US$ by Australians, they will sell A$ and buy US$

1-7

Determinants of exchange rate in freely floating system  Differences

in income growth

 Differences

in inflation rate

 Differences  Political

1-8

Currency risks in exchange rate systems 

Volatility and skewness 

Currency risk in floating exchange rate systems High volatility based on historical data History provides data that indicates past currency volatility

in real interest rate

and financial risks

 Expectations

Statistical measures of currency risk



Currency risk in pegged exchange rate system Zero volatility based on historical data The true currency risk does not show up in day-to-day fluctuations of the exchange rate (latent risk)

and central bank reputation

1-10

1-9

2. The history of exchange rate system

1-11

Major events in the history of FX rates

Recent currency crises

1946 Bretton Woods Conference

1971

1991

IMF was created



Mexican peso crisis of 1995

Exchange rate turmoil begins the modern era of floating exchange rates



Asian contagion of 1997

Jamaica Agreement (1976)



Russian ruble crisis in 1998

European Monetary System (1979)



Brazilian real crisis in 1998



Argentinian peso crisis of 2002

Treaty of Maastricht Introduction of the euro (1999) Euro begins public circulation (2002)

1-14

1-13

Asian currency values: $/unit Currency crises

(Dec 1996 = 1.00)



Contributing factors in each crisis - A fixed or pegged exchange rate system that overvalued the local currency - A large amount of foreign currency debt

Thai baht



Consequences of currency crises - Currency crises have a pronounced negative shortterm impact on the local economy

Korean won Indonesian rupiah

- A market-based exchange rate can have an invigorating long-term impact on the local economy and on the local stock market

1-16

1-15

The debate over IMF lending 

Proponents of IMF lending policies believe - Short term loans help countries overcome temporary financial crises



Critics of IMF lending believe

3. How are exchange rate systems controlled? --The role of central banks

- Fiscal constraints and capital market liberalizations increase economic and financial risks - IMF loans can leave a legacy of debt that can last for decades - IMF loans are often spent trying to support an unsustainable exchange rate - IMF remedies benefit developed countries and not the country in crisis 1-17

The central bank’s balance sheet

The central bank To understand how the exchange rate systems operate, you must first understand the functioning of central banks. Assets

Liabilities

Official international reserves

Deposits of private financial institution

Domestic credit

Currency in circulation

• Gold reserves (14%) Domestic credit •

The purchase or sales of government bonds by the central banks are used to influence the money supply

Loans to domestic financial institutions are important in times of panic and financial crisis Deposits of private financial institution (bank reserves) •

Government bonds Loans to domestic financial institutions Other

Other

Official international reserves • Foreign exchange reserves (86%)

•

Countries require their commercial banks to hold a certain percentage of the deposits the banks accept from the public

Currency in circulation •

The coins and bills are used by the public 1-20

1-19

Questions: Let us assume 1 A$= 1 US$

Foreign exchange rate intervention  Central

banks intervene in foreign exchange markets to affect exchange rates directly

---Reserve Bank of Australia buys A$5 billion Australian government bonds. What is the outcome on the Australian dollar? What about the impact on inflation in Australia?

--Reserve Bank of Australia buys US$5 billion US government bonds. What is the outcome on the Australian dollar? What about the impact on inflation in Australia?

• By supplying domestic currency, central banks weaken the value of domestic currency. • By demanding domestic currency, central banks strengthen the value of domestic currency. 

--Reserve Bank of Australia buys US$5 billion US government bonds and sells A$5 billion Australian government bonds. What is the outcome on the Australian dollar? What about the impact on inflation in Australia?

Two methods of foreign exchange rate intervention • Non-sterilized interventions (currency value and inflation) • Sterilized interventions (currency value)

1-22

The desire of a stable currency system in Europe 

4. The road to monetary integration in Europe

The desire for currency stability in Europe is extremely strong

 Western European countries are open to foreign trade and their trading partners are their neighboring countries  Facilitate the operation of a common market for agricultural products  Achieve the integral part of the wider drive toward economic, monetary, and political union among European countries

1-24

Was the European Monetary System successful?

The European Monetary System 

From 1944 to 1973, stability was supplied by the Bretton Wood system of fixed exchange rates



After the breakup of the Bretton Woods system, these western European countries established the European Monetary System in 1979

Day-to-day variability was down • Large revaluations did occur due to a currency crisis from 1992-1993 Inflation and interest differentials narrowed

 A grid of bilateral fixed central parities from which exchange rates can deviate by 2.25% on each side

• Could have been due to “hard” currency policies Asymmetric adjustments

 Interventions by central banks were compulsory whenever either bilateral margin was reached  If the grid of bilateral fixed central parities can not be sustained, a new grid will be established

• Central role of Germany; others maintained stable rate of their currency around Germany

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1-25

Euro Zone (2013)

The Maastricht Treaty and the Euro In 1991, the European heads of state met in Maastricht in the Netherlands to map out the road to economic and monetary union with a single currency to be reached by 1999 Criteria • Inflation within 1.5% of 3 best performing countries • Interest rate on long-term government bonds within 2% of those of 3 best-performing countries • A budget deficit to GDP 1  For each spot rate, sell the currency in the denominator for the currency in the numerator

1-23

Kirt C. Butler, Multinational Finance, 4e, 2008, John Wiley & Sons Ltd

Week 4 Transaction Exchange Risk and Forward Contracts 1. Transaction Exchange Risk 2. Forward Contracts 3. Rationale for Hedging Exchange Risk

1. Transaction exchange risk --possibility of taking a loss in foreign exchange transactions

1-1

Suppose Rio Tinto will receive $3 million from US Steel Corporation one year later (Aug. 20th, 2014). The current spot rate is A$1.09/$. Does Rio Tinto suffer any currency risk?

Transaction Exchange Risk  Who

incurs transaction exchange risk? • Corporations • Institutional investors • Individuals

 How

to avoid? • Hedging Protect against losses and get rid of uncertainty

1-3

1-4

Suppose Rio Tinto will receive $3 million from US Steel Corporation one year later (Aug. 20th, 2014). The current spot rate is A$1.09/$. Rio Tinto expects $ depreciates to A$1.0/$. 2. Forward contracts

Is there any method to hedge against currency risk?

1-6

Kirt C. Butler, Multinational Finance, 4e, 2008, John Wiley & Sons Ltd

Forward Contract

Dollar forward contract:

Date to sign this contract: Aug. 20th, 2013 Parties: Rio Tinto (US dollar seller) ...