Introduction and Course Overview

Introduction and Course Overview 1 Outline Brief course description Course requirements Outline of topics What is international finance? International monetary system © Prof. Ingrid M. Werner, Bus-Fin 725

Brief course description • This course extends the principles of investment analysis and financial management to the international environment. • The goal is to provide a framework for making financial decisions in an international context. • The course is divided into three sections: • The international financial environment • The globalization of world capital markets • Topics in international corporate finance © Prof. Ingrid M. Werner, Bus-Fin 725

Pre-requisites • The following courses are required background • Bus-Adm 555 • Bus-Fin 620 • The following courses are also recommended • Bus-Fin 721 • Bus-Fin 722 • If you are shaky on topics such as discounted cash flow and net present value, calculating risk and returns, and the basics of statistics (mean, variance, covariance, random variables, correlations, and regressions), dust off your old notebooks now and get yourself up to speed! • You should also be comfortable with Excel. © Prof. Ingrid M. Werner, Bus-Fin 725

Course resources • Textbook (required): • Cheol S. Eun and Bruce G. Resnick, International Financial Management 3rd ed., 2004 (McGraw-Hill) • Lecture Notes and Miscellaneous Other Materials: • Available for download on the course web-page: http://fisher.osu.edu/fin/faculty/werner/725/725iwwi06.htm • I will provide the username and passwordthat you will need in order to access password protected materials for the course. • I will bring no copies to class, so please make sure to download the necessary material before class. © Prof. Ingrid M. Werner, Bus-Fin 725

Grades • Final grades for the course will be determined as follows: • Homework assignments 15% • Case 5% • Midterm 40% • Final Exam 40% © Prof. Ingrid M. Werner, Bus-Fin 725

Homework assignments • There will be three (3) homework assignments. • Homework assignments will be long and involved. The only way to learn this material is to practice it. • Assignments can be individual or done with a partner. • Homework 1 is due on January 25. • Homework 2 is due on February 20. • Homework 3 is due on March 8. • Assignments are due at the beginning of class – late assignments are not accepted. • If you miss a homework assignment for a legitimate reason, the weight for the assignment will be re-allocated to the final exam. © Prof. Ingrid M. Werner, Bus-Fin 725

Exams • There will be two exams. • They will cover material from lectures, assigned readings, and assigned problems. • Exams are closed book and closed notes. You may bring a formula sheet (to be handed in with the exam) and you should bring a calculator. • Midterm is on February 8. • Final is on March 13 (Final Exam Week) • Absence from any exam will not be excused except for the most serious reasons. Such serious circumstances must be validated in writing by an appropriately accredited professional (I.e. medical doctor). If you miss the midterm for a legitimate reason, the weight for the midterm will be re-allocated to the final exam. © Prof. Ingrid M. Werner, Bus-Fin 725

Class participation and lectures • Class participation may factor into grading positively in the event that a student is on the border between grades. • In a similar fashion, repeated breaches of classroom etiquette could negatively impact a student on the border; constant tardiness or other disruptive behavior is unacceptable. • Lectures exceed the scope of the textbook at times. Therefore, attendance is important. You are responsible for all announcements made in class and on the web-page. • I will teach under the assumption that students have read the assigned readings before class. © Prof. Ingrid M. Werner, Bus-Fin 725

Course outline • Introduction to international finance • Introduction and course overview • The foreign exchange market • Parity conditions in international finance • Foreign exchange options • International investment analysis • International equity markets • International bond markets and swaps • International diversification and asset pricing • International asset allocation © Prof. Ingrid M. Werner, Bus-Fin 725

Course outline (continued) • International corporate finance issues • Risk management and transactions exposure to exchange rates • Risk management and operating exposure to exchange rates • International capital structure and the cost of capital • Discounted cash flow analysis in an international context • HBS Note on Cross-Border Valuation 9-292-084 • Foreign direct investment and political risk • Cases • Mini cases from textbook • Offshoring at Global Information Systems, Inc. HBS 9-204-144 © Prof. Ingrid M. Werner, Bus-Fin 725

Currencies and Crises • Exchange rate systems • Floating • Managed float • Pegged • Currency crises • the breakdown of the Bretton Woods system in spring 1971 • the collapse of the Smithsonian Agreement in late winter 1973 • the ERM crisis of 1992-93 • the Mexican devaluation and the tequila hangover of 1994-95 • the Asian flu of 1997-98 • Argentina 2001-02 • Turkey 2001 Source: Glick and Rose (2003) © Prof. Ingrid M. Werner, Bus-Fin 725

Currency crises © Prof. Ingrid M. Werner, Bus-Fin 725

Dabhol project - 1995 Controversy over Enron’s Dabhol project in Maharashtra state has raged since April 1992 when Houston-based Enron was invited to bid for the project as part of India’s economic liberalization drive. The issue, which pits local people against a global energy corporation, has generated endless controversy, including protest rallies, environmental concerns, charges of human rights abuses, court cases and political skullduggery. Venezuela -- 2004 In July, 2004, the United States Overseas Private Investment Corporation (OPIC), a U.S. government agency established to oversee the political risks of U.S. investments in foreign countries, issued a ruling accepting SAIC’s allegations of PDVSA’s "expropriation" of its assets and awarded the firm compensation from the U.S. government for a not yet determined amount of dollars. Political risk © Prof. Ingrid M. Werner, Bus-Fin 725

Political risk Source: http://www.prsgroup.com/yearbook/ © Prof. Ingrid M. Werner, Bus-Fin 725

Market imperfections Source: http://mkaccdb.eu.int/cgi-bin/stb/mkstb.pl?action=measures © Prof. Ingrid M. Werner, Bus-Fin 725

Government intervention Source: Hermann and Santoni (1988) Source: http://www.ecb.int/pub/pdf/scpwps/ecbwp465.pdf © Prof. Ingrid M. Werner, Bus-Fin 725

Goals for international financial management • Shareholder wealth maximization is our goal. • This does not mean that we only need to be concerned about shareholders! • The value of the firm will be affected by the actions of a broader set of stakeholders (Jensen and Meckling, JFE (1976)): • Shareholders • Bondholders • Management • Employees • Customers • Suppliers © Prof. Ingrid M. Werner, Bus-Fin 725

Managing international risks? • We should only consider taking actions to reduce (i.e., “hedge”) risks that arise from operating in an international environment if we truly believe that this will enhance the value of the firm. • The value of the firm is the discounted value of expected future net cash flows, where net means after the firm has paid all stakeholders (e.g., employees). • If managing risk is going to increase the value of the firm, it either has to: • Reduce the discount rate (cost of capital) • Increase the expected future cash flows © Prof. Ingrid M. Werner, Bus-Fin 725

Jamaica Agreement Plaza Accord Louvre Accord © Prof. Ingrid M. Werner, Bus-Fin 725

International monetary system • Classic gold standard: 1875-1914 • Gold alone is assured of unrestricted coinage • There is a two-way convertibility between gold and national currencies at a stable ratio • Gold may be freely exported and imported • The gold standard provided a 40 year period of unprecedented stability of exchange rates which served to promote international trade (U.S. dollar remained in a $4.84-4.90 range!). • Interwar period: 1915-1944 • Trade in gold broke down, and countries started to “cheat.” • Bretton Woods system: 1945-1972 • U.S. dollar was pegged to gold at $35.00/oz. • Other major currencies established par values against the dollar. Deviations of ±1% were allowed, and devaluations could be negotiated. © Prof. Ingrid M. Werner, Bus-Fin 725

International monetary system • Flexible exchange rate regime: 1973-Present • Jamaica Agreement (1976) • Central banks were allowed to intervene in the foreign exchange markets to iron out unwarranted volatilities. • Gold was officially abandoned as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with proceeds used to help poor nations. • Non-oil exporting countries and less-developed countries were given greater access to IMF funds. • Plaza Accord (1985) • G-5 countries (France, Japan, Germany, the U.K., and the U.S.) agreed that it would be desirable for the U.S. dollar to depreciate. • Louvre Accord (1987) • G-7 countries (Canada and Italy were added) would cooperate to achieve greater exchange rate stability. • G-7 countries agreed to more closely consult and coordinate their macroeconomic policies. © Prof. Ingrid M. Werner, Bus-Fin 725

Current exchange rate arrangements • 73 currencies, such as the U.S. dollar, the Japanese yen, the Euro, and the British pound are determined largely by market forces. • 30 countries, including China, Egypt, Indonesia and Singapore, adopt some forms of “Managed Floating” system. • Many countries do not have their own national currencies! • 55 countries, including Hong Kong, several Carribbean islands and Estonia, do have their own currencies, but they maintain a peg to the U.S. dollar or the German mark. • The remaining countries have some mixture of fixed and floating exchange-rate regimes. © Prof. Ingrid M. Werner, Bus-Fin 725

The Argentine peso $-peg instituted in April 1991 by Cavallo under President Menem’s term in office Dual exchange rate system in December 2001; Preferential exchange rate for exports $ appreciation Argentine peso was devalued in January 2002; $-peg was abandoned Brazil’s real currency crisis of 1999; Presidential elections in Dec.1999 © Prof. Ingrid M. Werner, Bus-Fin 725

The Turkish lira Hyperinflation IMF forces Turkey to adopt a crawling peg against the $ and the €; Slow depreciation until 2003 was the idea… Interbank lending rates 5,000% 02/22/2001 crawling-peg abandoned; Turkish Lira depreciates > 30%; ultimately > 40% © Prof. Ingrid M. Werner, Bus-Fin 725

The Turkish lira • The monetary unit of Turkey is the new Turkish lira (YTL), divided into 100 new kurus. • The devalued YTL was introduced on January 1, 2005, and replaced the old Turkish lira (TL, to remain legal tender until the end of 2005). • Due to chronically high inflation rates since the 1970s, the TL had experienced a severe depreciation in value, with one million TL equal to approximately U.S. $0.75 cents in late 2004. • The devaluation of the YTL, which followed Turkey’s success in reducing inflation, dropped six zeroes from the old TL in a million-to-one conversion. • The devaluation required Turkey to begin minting a new kurus, as the old kurus had been dropped years ago due to inflation. • The Central Bank of the Republic of Turkey, founded in 1930, is the bank of issue. © Prof. Ingrid M. Werner, Bus-Fin 725

The revaluation of the renminbi • Figure 1 shows the market reaction to the announcement by graphing the daily closing values of the renminbi-dollar spot exchange rate and the two-month renminbi non-deliverable forward (NDF) rates around the time of the revaluation. • Although these forward contracts constitute a relatively thin market, they can be considered the best indicator available of the market's beliefs about the future path of the renminbi-dollar exchange rate. • At the end of July 21, the market anticipated further renminbi appreciation, as the two-month NDF renminbi-dollar exchange rates stood below 8 renminbi per dollar. Forward rate © Prof. Ingrid M. Werner, Bus-Fin 725

Will the UK join the euro club? • The Mini-Case can be found in E&R. • Think about: • Potential benefits and costs of adopting the euro. • Economic and political constraints facing the country. • The potential impact of British adoption of the euro on the international financial system, including the role of the U.S. dollar. • The implications for the value of the euro of expanding the EU to include, e.g., Eastern European countries. © Prof. Ingrid M. Werner, Bus-Fin 725

Wrap-up • Globalization, in combination with flexible exchange rates, has increased the risks faced by investors and firms alike. • Managing those risks will be a key concern for managers. • The international monetary system has moved from fixed exchange rates to more flexible regimes. • However, even today there are many countries that peg their currencies to e.g., the U.S. dollar © Prof. Ingrid M. Werner, Bus-Fin 725

Introduction and Course Overview