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					International Finance

      Chapter 18
          International Finance
• Total global trade (as measured by exports):
   – 1948: $58 billion
   – 2008: $16.1 trillion
   – From 1948 to 2008, increase of 27,805%, or
     roughly 10% per year compounded
• This trade is underpinned by an international
  financial community consisting of multinational
  banks, global stock markets, and multinational
  corporations.
                    Currencies
A Short History of Fixed Exchange Rates
• “Gold standard”: (prior to the 1929 Stock Market
  crash) a nation’s currency was directly convertible
  into gold at a fixed exchange rate
   – Gold flowed out of a country that ran a balance of
     payments deficit
   – Gold flowed into a country that ran a balance of
     payments surplus
   – This fixed exchange rate regime was seen as a form of
     discipline on countries to maintain a balance of
     interest rates and trade, though it was subject to
     breakdown if a country ran low on gold
                   Currencies
A Short History of Fixed Exchange Rates
• Depression of 1929-1941
• Countries went off the gold standard as
  domestic needs took precedence over orderly
  international trade relations
• Protectionism curtailed trading between
  countries – Smoot-Hawley tariff of 1930
• World War II
                   Currencies
A Short History of Fixed Exchange Rates
• Bretton Woods: 1944 agreement which
  established a new fixed currency regime with
  the dollar as the anchor and in turn, the dollar
  was tied to gold at a fixed price of $35 per
  ounce
   – Led to the creation of the International Monetary
     Fund, the World Bank, the General Agreement on
     Tariffs and Trade (today’s World Trade
     Organization)
                   Currencies
A Short History of Fixed Exchange Rates
• Inflation in the 1960’s and consequent
  escalating commodities prices led President
  Nixon to “close the gold window” in August
  1971, effectively ending the Bretton Woods
  exchange rate regime.
                  Currencies
Floating Exchange Rates
• Floating exchange rate: exchange rate
  between two currencies can move in price
  each day
  – Value of currencies is determined by supply and
    demand in marketplace.
                   Currencies
Floating Exchange Rates
• Under the floating exchange rate regime,
  international businesses must account for
  currency translation risk.
  – Currency translation risk: risk that value of foreign
    currency changes in a way which makes business
    less profitable, absent an exchange rate
    “devaluation”
                  Currencies
Floating Exchange Rates
• Exchange rate of a particular currency with U.S.
  dollar is either:
  1. How many dollars it takes to buy one unit of
     foreign currency
  2. How many units of foreign currency it takes to buy
     one dollar
• Cross rate (American perspective): exchange rate
  between two foreign currencies because it can be
  calculated by multiplying their rates relative to
  the U.S. dollar
       Futures, Options and Swaps
• Securities and other contractual mechanisms
  that help businesses hedge their currency
  translation risk:
  1.   Forward contracts
  2.   Future contracts
  3.   Option contracts
  4.   Swap Agreements
         Future, Option and Swap
1. Forward contracts: privately negotiated
   agreements under which one party (often
   commercial bank) would agree to purchase
   another currency from counterparty at some
   fixed rate at some defined point forward in time
  – Terms negotiated between parties:
     •   Type of currency
     •   Rate
     •   Time for forward delivery
     •   Mechanism (physical delivery or cash settlement)
  – Each contract is a “one-off” deal
  – Rarely secondary trading or securitization of contract
        Futures, Option and Swap
2. Futures contracts: traded on an exchange
  – E.g. Chicago Mercantile Exchange
  – Standardized terms of contract:
    •   Quantity of currency
    •   Rate
    •   Time of delivery
    •   Mechanism for settlement (generally cash settlement)
  – Merc facilitates liquidity in any particular
    contract, albeit at the expense of individual
    tailoring that a forward contract can provide.
        Future, Option and Swap
3. Option contracts: one party pays a price
   (premium) to have the right to buy (for a call
   option) or sell (for a put option) a certain
   amount of currency at a defined price (called
   the strike price)
  – Priced based on elaborate financial models
    •   Many are derived from Black-Scholes option pricing
        model by Fisher Black and Myron Scholes in the early
        1970’s.
        Future, Option and Swap
4. Swap agreements: privately negotiated agreements
   between parties under which one party agrees to
   trade (or swap) a risk it bears with a counterparty in
   exchange for an instrument that does not have that
   risk
  –   E.g. Interest rate swap: one party that is bearing interest
      risk through a floating interest rate will agree to swap
      floating rate for a fixed rate from counterparty
  –   There may be explicit fee associated with swap
  –   Fee may be embedded into terms of swap
  –   Borrower benefits by locking in a fixed rate and
      counterparty benefits from the fee income it generates
      for swap
       Future, Option and Swap
4. Swap agreements (continued)
  – Swap agreements that hedge currency risk: one
    party agrees to swap steam of cash flows in one
    currency for that same set of cash flows in a different
    currency
  – Credit default swaps: one party swaps its credit
    default risk, an upfront fee and series of annual fees,
    until expiration of swap to counterparty in exchange
    for assurance of payment of notional value of swap
    contract in the event that the underlying company
    defaults on payments of its debt securities
               Money Markets
• International money market: international debt
  securities with maturities of 12 months or less
• Eurodollar market: debt securities denominated
  in several different currencies with U.S. dollar
  being most prevalent
• Eurodollar: any dollar located outside the U.S., or
  currency borrowed in London money market at
  London Interbank Offered Rate (LIBOR)
   – 90 day LIBOR: benchmark short term rate, or proxy for
     what it costs for one bank to borrow from another for
     a short period of time
               Money Markets
• Interest equalization tax (1963)
  – Made repatriating dollars more expensive than
    keeping them abroad
  – Caused international banks to look for a way to
    borrow and lend in dollars outside the U.S. – directly
    led to creation of Eurodollar market
• Eurodollar market today
  – Large, generally steady, liquid market
  – Banks lend to each other at the LIBOR
  – Banks use LIBOR as proxy for their cost of funds and
    charge their best customers some spread over LIBOR
              Money Markets
• Interest rate parity
  – Interest rates charged in international money
    market are tied to exchange rates of underlying
    countries
  – No-arbitrage condition that must hold, on
    average, over time
  – Difference in forward exchange rate for two
    countries’ currencies must equal difference
    between interest rates in those countries
              Money Markets
Interest Rate Parity
• “Carry trade”: hedge funds borrowed money
  in Japan at low interest rates on assumption
  that the Yen would not appreciate sufficiently
  to offset interest rate differential
  – From mid-2002 to July 2007, the Yen/Dollar
    exchange rate was stable, but broke down in July
    2007 - January 2009 time period
  – Hedge funds which had borrowed in Yen were
    stuck with massive losses
               Capital Markets
• In the immediate aftermath of World War II,
  American capital markets were dominant in
  the world finance.
• Over the past sixty plus years, New York has
  gradually decreased in importance as a global
  financial center.
• The result of this is that global capital raising is
  more dispersed with regional centers such as
  London and Hong Kong rising in importance
               Capital Markets
• Trading occurs among major market centers
  around the world and across time zones!
  – Business managers face risks and opportunities
  – Company can list its shares on one of many different
    financial markets
  – Financial firms need individuals in various locations in
    order to meet global clients’ demands
  – Global risk managers need to be alert to changes in
    market conditions, interest rates, and exchanges rates,
    and the consequent effects on business conditions

				
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Description: International Finance