International Finance: Markets, Risks, and Strategies

Posted on Mar 6, 2025 in Accounting and Finance

Chapter 1: Multinational Enterprises and Globalization

A Multinational Enterprise (MNE) has operating subsidiaries, branches, or affiliates located in foreign countries.

Globalization is the process of producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national borders.

Transnational refers to companies with widely dispersed ownership.

Domestic Firms’ International Activities

• Import and export of products, components, and services.
• Licensing of foreign firms to conduct their foreign business.
• Exposure to foreign competition in the domestic market.
• Indirect exposure to international risks through relationships with customers and suppliers.

Global Business is the social science of managing people to organize, maintain, and grow collective productivity to generate profit and value for its owners and stakeholders. It requires an open marketplace, strategic management, and capital.

Risks include fluctuating exchange rates, fiscal policy changes, balance of payments issues, and changing capital markets.

Assets, in this context, are debt securities issued by governments (bonds). These form the baseline and are considered low risk.

Institutions, such as central banks and commercial and investment banks, are crucial. Their health keeps the global financial system stable.

Linkages are the interbank networks using currency. Without a ready exchange of currencies, the market is hard-pressed to operate efficiently.

Eurocurrencies Market

The Eurocurrency market consists of domestic currencies of one country on deposit in a second country.

It serves two purposes: It is an efficient and convenient money market device for holding excess corporate liquidity. It is a source of short-term bank loans to finance corporate working capital needs.

LIBOR (London Interbank Offered Rate) is a reference rate of interest. It reflects “pure” market-driven currencies and instrument rates and is largely unregulated.

Comparative Advantage

Comparative advantage is a concept used to explain and justify international trade in a model world characterized by free trade, perfect competition, no uncertainty, costless information, and no government interference.

The theory includes the following features:

• Exporters in Country A sell goods or services to unrelated importers in Country B.
• Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production (land, labor, capital, and technology).
• Firms in Country B do likewise, given the factors of production found in Country B.
• In this way, the total combined output of A and B is maximized.
• Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries.
• Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally.

Limitations: This model is not entirely realistic. Countries do not always specialize in goods that could be most efficiently produced due to government interference. At least two factors of production (capital and technology) flow easily between countries. Modern factors of production are more numerous. Less developed countries can become developed. The model does not address the effects of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale.

The comparative advantage of the 21st century is based more on services and their cross-border facilitation by telecommunications and the Internet.

A nation’s comparative advantage is still created from the mixture of its labor skills, access to capital, and technology.

Market Imperfections

Market imperfections create opportunities. Large international firms are better able to exploit competitive factors such as economies of scale, managerial and technological expertise, product differentiation, and financial strength than their local competitors.

Strategic Motives for Multinational Enterprises

• Market seekers: Produce in foreign markets either to satisfy local demand or to export to markets other than their home market.
• Raw material seekers: Search for cheaper or more abundant raw materials in foreign countries.
• Production efficiency seekers: Produce in countries where one or more of the factors of production are cheaper.
• Knowledge seekers: Gain access to new technologies or managerial expertise.
• Political safety seekers: Establish operations in countries considered less likely to expropriate or interfere with private enterprise.

Proactive investments are designed to enhance the growth and profitability of the firm itself.

Defensive investments are designed to deny growth and profitability to the firm’s competitors.

Twin Agency Problem: This refers to whether insiders or leaders are taking consistent actions to create firm value or increase their own personal stakes. It prevents the flow of capital across borders, currencies, and institutions.

International, Multinational, Global – International means that the company has some form of business interest in more than one country. Multinational usually means a company that has operating subsidiaries and performs a full set of its major operations in several countries. Global is a newer term that essentially means the same as “multinational,” i.e., operating around the globe.

Reasons for becoming multinational: new markets, acquisition of raw materials, greater efficiency, knowledge, economies of scale.

Ganado engages in international trade and has foreign sales/service offices.

Chapter 2: Financial Goals and Corporate Governance

Gold Standard: Each country determined the price of gold in their country, which was then used to determine exchange rates (which were fixed). Expansion of monetary policy was not possible; every dollar or pound had to be backed up by gold.

Interwar Years: Currencies were allowed to fluctuate. After World War II, the US dollar was the only major trading currency.

Bretton Woods: After World War II, this agreement established a U.S. dollar-based international monetary system and created two new institutions: the International Monetary Fund (IMF) and the World Bank (WB).

IMF: Helps countries defend their currency and assists countries having structural trade problems.

The International Bank for Reconstruction and Development (WB): Helped fund post-war reconstruction and has since supported general economic development.

The U.S. dollar became the main reserve currency held by central banks, resulting in a consistently growing balance of payments deficit. This required a heavy capital outflow of dollars to finance these deficits and meet the growing demand for dollars from investors and businesses.

Central Bank: Responsible for monetary policy. Government: Responsible for fiscal policy.

A heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the U.S. to meet its commitment to convert dollars to gold, leading to the devaluation of the dollar. The fixed exchange rate system ended in 1973.

Floating Era of Eclectic Arrangement (1973-1997): Exchange rates (ER) became more volatile and less predictable.

Emerging Era (1997-present): More emerging market economies with increasing complexity, leading to more emerging market currencies.

Fixed vs. Floating Exchange Rates

Fixed Rates:

• Hard Peg: The central bank (CB) must back up the entire supply of money in circulation with appropriate resources. They cannot introduce a single unit of currency without having it backed up.
• Soft Peg (Dominant): The CB fixes the rate but doesn’t have enough reserves to back up each unit of the currency.

Floating Rates (Market-Driven):

• Managed Float: The CB intervenes from time to time to keep the rate within certain boundaries, trying not to put the entire economy at risk. They still allow it to fluctuate.
• Crawling Peg: The country fixes the rate of its currency but increases or decreases it to revalue it.

Euro: Floating against other countries, but within the Eurozone, it is a fixed rate. There is no exchange rate risk within the EU because all members use the same currency.

Choosing an Exchange Rate Regime: Factors to consider include inflation, unemployment, interest rates, trade balances, and economic growth.

Why Fixed Rates? Stability in international prices and an inherent anti-inflationary nature. Problems? The CB needs a large quantity of hard currencies to defend the fixed rate. It can be maintained at rates inconsistent with economic fundamentals.

The Impossible Trinity

An ideal currency possesses exchange rate stability, full financial integration, and monetary independence. It’s impossible to have all three; a marginal compromise must be made. Decide what to pursue and what to give up.

Impact of the Euro

The Euro leads to cheaper transaction costs in the Eurozone, reduced currency risks and costs related to uncertainty, and increased price transparency and price-based competition for consumers.

The primary driver of a currency’s value is its ability to maintain purchasing power. The largest threat is inflation.

Currency Board: A country’s CB commits to backing its money supply entirely with foreign reserves. A unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being added first.

Dollarization: The use of the US dollar as the official currency of a country. Why? Sound monetary and exchange rate policies do not depend on the intelligence or discipline of domestic policymakers.

Common Features of Emerging Markets (EM): Weak fiscal, financial, and monetary institutions; tendencies for commerce to allow currency substitution and the denomination of liabilities in dollars; vulnerability to sudden stoppages of outside capital flows.

Chapter 3: The Balance of Payments

The Balance of Payments (BOP) must balance. It is a measurement of all international economic transactions between residents of a country and foreign residents.

• Indicates pressure on foreign exchange reserves (FER).
• Signals the potential removal of controls on various payments.
• Forecasts a country’s market potential.

Credit: An event (e.g., the export of a good or service) that records foreign exchange earned – an inflow of foreign exchange.

Debit: Foreign exchange spent (e.g., payments for imports or purchases of services) – an outflow of foreign exchange.

The cash flow statement includes current, capital, and financial accounts. It doesn’t add up the value of all assets and liabilities. The Official Reserves Account tracks government currency transactions. The Net Errors and Omissions Account preserves the balance of the BOP.

Deficit: Implies an excess supply of the country’s currency on world markets, and the government should devalue the currency or expend official reserves.

Surplus: Implies demand for the country’s currency exceeded supply, and the government should allow the currency value to increase or intervene and accumulate additional foreign currency reserves in the Official Reserves Account (buying pressure).

GDP = C + I + G + (X – M)

BOP = (X – M) + (CI – CO) + (FI – FO) + FXB (X and FI will increase if the exchange rate is used as a policymaking tool)

Capital Control: A restriction that limits or alters the rate or direction of capital movement into or out of a country.

Dutch Disease: The problem of substantial currency appreciation due to the demand for a specific natural resource faced by several resource-rich smaller nations.

Capital Flight: A rapid outflow of capital in opposition to domestic political and economic conditions.

Foreign Direct Investment (FDI): Motivated by control and profit. Portfolio Foreign Investment (PFI): Motivated by profit. A multinational industrial company would make a foreign direct investment. They may buy another company and use it to gain control in foreign countries.

Chapter 5: The Foreign Exchange Market

The Foreign Exchange (FE) Market is the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed.

Foreign Exchange: The money of a foreign country. Foreign Exchange Transaction: An agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date.

Functions of the FE Market

• Transfer purchasing power.
• Obtain or provide credit for international trade transactions.
• Minimize exposure to the risks of exchange rate changes.

Wholesale Market: Traditionally for big players. Client/Retail Market: Traditionally for smaller players. There used to be a smaller ‘spread’ in the wholesale market, which is why there were two tiers, but this is no longer the case.

Market Participants

1. Bank and Nonbank Foreign Exchange Dealers: Profit by buying foreign exchange at a bid price and reselling it at a higher offer/ask price.
2. Individuals and Firms: Conduct commercial and investment transactions in the foreign exchange market.
3. Speculators and Arbitragers:
   • Speculators: Earn from the price change of a commodity.
   • Arbitragers: Profit by identifying discrepancies in the market and capitalizing on them.
4. Central Banks and Treasuries: Use the market to acquire or spend their country’s foreign exchange reserves and to influence the price at which their own currency is traded. Their motive is not to earn a profit.
5. Foreign Exchange Brokers: Agents who facilitate trading between dealers without themselves becoming principals in the transaction. They expedite transactions and maintain anonymity.

Spot Transaction: The purchase of foreign exchange. Value Date: The date of settlement. Outright Forward Transaction: Delivery at a future value date of a specified amount of one currency in exchange for another currency. Swap Transaction: The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Foreign Exchange Rate: The price of one currency expressed in terms of another. Foreign Exchange Quote: A statement of willingness to buy or sell at an announced rate.

Direct Quote: The home currency price of a unit of foreign currency. Indirect Quote: The foreign currency price of a unit of home currency.

Bid: The price in one currency at which a dealer will buy another currency. Ask: The price at which a dealer will sell the other currency.

Cash Rates: Forward rates of one year or less maturity. Swap Rates: Forward rates of more than one year maturity.

Chapter 6: International Parity Conditions

International parity conditions are economic theories that link exchange rates, price levels, and interest rates. These theories only work under certain conditions, but often the issue is not with the theory itself, but with its interpretation and application.

Law of One Price

If an identical product or service can be sold in two markets, and no restrictions exist on the sale, and transportation costs of moving the product are equal, the product’s price should be the same in both markets. (Prices will equalize if transport costs don’t exist).

Conversion of currency: P^$ x S = P^¥

If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices.

Absolute Purchasing Power Parity (APPP): Once two currencies have been exchanged, a basket of goods should have the same value.

Relative Purchasing Power Parity (RPPP): The relative change in prices between two countries over a period determines the change in the exchange rate over that period.

PPP holds well in the very long run. It is better for countries with high inflation rates and underdeveloped capital markets.

Whenever the price is above 100, it indicates strong purchasing power (under 100 = lower purchasing power).

Exchange Rate Pass-Through: Measures how much the prices of imported and exported goods change as a result of exchange rate changes. Price elasticity of demand is an important factor when determining pass-through levels.

The Fisher Effect

Nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation (i = r + p). Empirical tests (using ex-post) national inflation rates have shown the Fisher effect usually exists for short-maturity government securities (treasury bills and notes).

International Fisher Effect

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the “Fisher-open” or International Fisher Effect.

It states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

Forward Rate

The forward rate is an exchange rate quoted for settlement at some future date. It is calculated by adjusting the current spot exchange rate by the ratio of Eurocurrency interest rates of the same maturity for the two subject currencies.

F^SF/$₉₀ = S_SF/$ x [1 + (i^SF x 90/360)] [1 + (i^$ x 90/360)]

F^sf = Spot – Forward x 360 x 100 Forward Days

Foreign currency price of home currency used (SF/$)

Interest Rate Parity (IRP)

IRP provides the link between foreign exchange markets and international money markets. The spot and forward exchange rates are not constantly in a state of equilibrium.

Covered Interest Arbitrage (CIA): Investors make a profit based on differences in interest rates and cover their position with a forward contract.

Uncovered Interest Arbitrage (UIA): Investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The investor does not sell the higher-yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk.

Chapter 7: Futures and Options

Speculation: An attempt to profit by trading on expectations about future prices. It involves attempting to profit in the spot market (believing the foreign currency will appreciate), the forward market, and the options market.

Hedging: The use of derivative instruments to reduce the risks associated with the everyday management of corporate cash flow.

Derivatives: Financial contracts whose values are derived from underlying assets. Benefits: Reduce the volatility of stock returns, reduce tax liabilities, and hedge risks.

Foreign Currency Futures Contract: Calls for future delivery of a standard amount of foreign exchange at a fixed time, place, and price. They differ from forwards in that they have a standard size, fixed maturity, organized trading on exchanges, and are rarely settled.

A Foreign Currency Option is a contract giving the buyer the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date). A call is an option to buy foreign currency. A put is an option to sell.

The buyer of an option is the holder. The seller of an option is the writer.

Elements of Currency Options

1. Strike Price: The exchange rate at which the foreign currency can be purchased or sold.
2. Premium: The cost, price, or value of the option.
3. Actual Spot Exchange Rate in the market.

US Option: Gives the buyer the right to exercise the option at any time between the date of writing and the maturity date.

EU Option: Can be exercised only on its expiration date, not before.

At the Money: An option whose exercise price is the same as the spot price of the underlying currency.

In the Money: An option that would be profitable if exercised immediately. Out of the Money: An option that would not be profitable if exercised immediately.

Buyer of a Call: If spot rates are below the strike price, the buyer wouldn’t exercise. If above the strike price, they would exercise, purchase, and sell.

Writer of a Call: Maximum profit equals the premium. A naked option is when the writer doesn’t own the currency (they would have to buy at the spot price and deliver at the strike price, resulting in a loss).

Buyer of a Put: Can never lose more than the premium paid up front. They want to be able to sell at the exercise price when the market price drops.

Writer of a Put: The option will be exercised if the spot price is below the strike price. If above, it won’t be exercised, and the writer pockets the entire premium.

Six Elements of Pricing Options

1. Present spot rate.
2. Time to maturity.
3. Forward rate for matching maturity.
4. US dollar interest rate.
5. Foreign currency interest rate.
6. Volatility.

Intrinsic Value: The financial gain if the option is exercised immediately. For a call option, it’s zero when the strike price is above the market price. It becomes positive when the spot price rises above the strike price. The opposite is true for put options.