International Finance

Introduction
 Today’s Objectives
• Understand the syllabus and how it works
• Understand my goals for this course
(teaching and learning objectives)
• Understand my philosophy of teaching
• Understand the focus of the course
• Understand FOREX transactions and the
role of arbitrage.

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Learning Objectives and Philosophy

• I want you to learn how to DO things

– Perform codified practices such as calculating
cross-exchange rates, currency and
intertemporal arbitrage, currency hedging
– Understand when and why to perform them, as
well as how
• Watch, Do, Teach

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 Our Focus
• We will focus on the institutions and
markets that “connect” nations’ economies,
especially financial sector linkages.
• More specifically, we will concentrate on
FOREIGN DIRECT INVESTMENT.

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 Real and Financial Sectors

• Real Sector: Production and sale of goods

and services; acquisition and divestiture of
capital assets.
• Financial Sector: Transactions in financial
assets: currency, bank deposits, bonds,
stocks, futures and options, etc.

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 International Economic
Integration
International economic integration refers to the
extent and strength of real- sector and
financial-sector linkages among national
economies. Real-sector linkages occur through
the international transactions in goods and
services while the financial-sector linkages
occur through international transactions in
financial assets.

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 The Rise of Multinational Firms
• Changes our definition of comparative Advantage
– Relative value-added -- product development, design, logistics,
assembly, marketing -- depends less on national differences and
more on firm-specific competencies and investments, although
these latter reflect national differences in factor endowments
– The range of a nation’s exports is equivalent to the range of its
exports
• Comparative Advantage in a world of
multinationals
– Most cross-border trade involves intermediate products, much of it
takes place within the boundaries of a single firm (a single Barbie
doll is made in 12 countries)

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 Evolution of the Multinational
Corporation (FDI)
• Raw materials seekers.
• Market seekers.
• Cost minimizers/product enhancers
– Coase -- firms exist where they reduce transactions (search,
bargaining, monitoring and enforcement costs) and logistics costs,
otherwise transactions would take place through markets. They
internalize externalities, economies of scale and scope (which give
rise to non-exhaustibility), thru creation of effective governance
institutions, that would obtain in a world without organizations.
– Some of these potential economies can be obtained by locating
operations where factor costs are lower.
• Flexibility, adaptability, & speed of response
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 International Financial
Management: Why?
• Financing & investment decisions that
maximize value added by firm
• Asset deployment & utilization to increase
PV future cash flows
– You must create value first before you can
distribute it
• True of Corp. Finance in general, so why
study IFM? What makes it different?
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 International Financial
Management: Why?
• Borders, different currencies
• BUT, if financial markets were completely
integrated, different currencies wouldn’t matter.
(Of course, if there were no real exchanges, you
wouldn’t need financial markets.) IN NEITHER
CASE WOULD WE BOTHER TO STUDY IFM!
• IFM deserves a special course only because
integration has gone far enough to give it
meaning, but not far enough to make it just like
domestic finance.
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 Functions of Financial Management:
Acquisition & Investment of Funds
Differences relevant to Constants relevant to international
international financial financial management
management • Arbitrage (APT)
• Exchange risks, taxes, multiple • Market efficiency
money markets (often w/limited – Herd behavior
access to credit, some • CAPM
w/currency controls), political – Systematic (undiversifiable)
risks risk
• Access to segmented money – Unsystematic (diversifiable)
risk
markets, shift profits to lower
taxes, reduce risk thru • Total risk
international diversification of • You cannot create value with
markets & production sites smoke and mirrors

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 FOREX

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Multinational Policymaking

The International Financial

Architecture
 International Financial
Architecture
• The international financial architecture is comprised of
the institutions, governmental and non-government
organizations, and the policies that govern activity in the
international monetary and financial markets.
• Since the collapse of the Bretton Woods system that most
important aspect of the international financial system is the
growth of capital flows among nations.

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 Capital Market Liberalization
• Advocates of liberalized capital flows argue
that unhindered capital flows allow savings
to flow to their most productive use,
resulting in the development of real
resources and higher productivity.
• Financial market imperfections may result
in capital misallocations and financial
instability.
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 Financial Instability and
Financial Crisis
• Financial instability occurs when the financial
sector is unable to allocate funds to their most
productive use.
• A financial crisis is a situation where a nation’s
financial system is no longer able to function. A
financial crisis typically involves
– a banking crisis,
– a currency crisis, and
– a foreign debt crisis.
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 Capital Flows and
Financial Crisis
• International capital flows consists of short-
term (primarily portfolio) capital flows, and
long-term (primarily foreign direct
investment) flows.
• An excessive reliance on portfolio capital
can be destabilizing and may contribute to
financial crises.

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 Multilateral Policymaking
• The two organizations at the center of efforts to stem
international financial crises are:
• The International Monetary Fund: a multinational
organization the promotes international monetary policy
cooperation, exchange arrangements, and economic
growth.
• The World Bank: A sister institution that specializes in
making loans to developing nations to promote
development and growth.

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 Can these Organizations
Predict a Crisis?
• To predict a crisis, policymakers must have
an idea of their cause. Potential sources of
financial crisis are:
– An inconsistency between the exchange rate
and economic fundamentals.
– Speculative attacks.
– Structural moral hazards.

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Balance-of-Payments
Accounts and Net
Financial Flows
 Financial Inflow
• Balance of Payments is a flow account, which consists of the current account
and the capital and financial account
• A flow of capital, real and/or financial, into a country, takes the form of
increased purchases of domestic assets by foreigners and/or reduced holdings
of foreign assets by domestic residents. Inflows are recorded as positive, or a
credit, in the capital and financial account.
• Each country also has an international balance sheet, which is a stock account
which shows assets and liabilities abroad and foreign assets and liabilities at
home -- Called the international investment positions accounts in the
U.S. (the accumulated stocks of U.S.-owned assets abroad and of foreign-
owned assets in the United States) .
• The net change in the international investment positions accounts from the
beginning of one year to the end of the next is the net capital/financial flow for
the year

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 Exchange and Net Flows
• Exchange of Real Assets – exchange of goods and
services for other goods and services or for financial
claims (will give rise to a net change in financial claims if
x≠m)
• Exchange of Financial Assets – Exchange of financial
claims for other financial claims (net financial claims are
unchanged)
• Hence, m-x = net capital flow, also = I-S
[ignoring reporting errors and official settlements]

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 Balance of Payments Statistics for the
United States, 1966
(Amounts in millions of dollars)

Sources of Foreign Exchange Uses of Foreign Exchange

• Exports of Goods and Services $43,142 • Imports of Goods and Services $38,063
• Remittances and Pensions $1,015
Balance on goods, services, remittances,
and pensions +$4065
• U.S. Government grants, net $3,444
• Foreign Capital Flow, net $2,532 • U.S. private Capital Flow, net $4,298
• Errors and Omissions $210
Balance of all of the above -$1357

• Change in U.S. Reserve Assets $568

• Change in Liquid Liabilities of Foreign
Accounts $789
.

Source: Federal Reserve Bulletin, April 1969, pp A70-71

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The Balance of Payments
Accounting System
International Bookkeeping
 International Transactions
Accounts (Balance of Payments)
A quarterly statistical summary of
transactions between U.S. and foreign
residents organized into three major
categories:
– The current account
– The capital account
– The financial account

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 Balance of Payments
• System of accounts which is a subset of the
National Income and Production Accounts
– A double-entry bookkeeping system.
– Debit Entries: Transactions that generate a
payment outflow (e.g., import).
– Credit Entries: Transactions that generate a
payment inflow (e.g., export).

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 Balance of Payments
• The current account includes exports and
imports of goods, services, income, and
current transfers.
– Goods
– Services
– Income Receipts and Payments
– Unilateral Transfers

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 Balance of Payments
• Goods: Exports and imports of tangible
items.
• Services: Exports and imports of services,
for example:
– Typical business services such as banking and
financial services, insurance, and consulting.
– Tourism

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 Balance of Payments

• Income Receipts: Includes items such as

– Investment income on US-owned assets abroad.
– Receipts of income on US direct investment
abroad.
– Government income receipts

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 Balance of Payments
• Income Payments: Includes items such as
– Investment income on foreign-owned assets in
the United States.
– Payments of income on foreign direct
investment in the United States
– US Government income payments

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 Balance of Payments
• Unilateral Transfers: Includes items such
as:
– Government grants abroad
– Private remittances
– Private grants abroad

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 Balance of Payments (2000)
Exports Millions 1,414,925
Goods 773,304
Services 296,227
Income Receipts 345,394
Imports -1,797,061
Goods -1,222,772
Services -215,239
Income Payments -359,050
Unilateral Transfers -53,241
Current Account Balance -435,377
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 Balance of Payments
The Financial Sector
• In June 1999, US capital account definitions were
modified to bring them more in line with definitions
recommended by the International Monetary Fund.
• Now there are two accounts:
– The capital account includes capital transfers, such as debt
forgiveness.
– The financial account includes transactions for official assets, for
U.S. Government assets other than official reserve assets, for
direct investment, for portfolio investment, and for other
investment.

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 Balance of Payments
The Financial Sector
• The new Capital Account includes items
that were previously included in unilateral
transfers, such as:
– Debt forgiveness
– Migrants’ transfers (as they leave the country).
• The new capital account is small for the US
(< 0.1 percent of capital flows), but
expected to grow.

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 Balance of Payments
The Financial Sector
• The Financial Account
– Records international transactions in the
financial sector
– Includes portfolio and foreign direct investment
– Includes changes in banks’ and brokers’ cash
deposits that arise from international
transactions.

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 Balance of Payments
The Financial Sector
• US-Owned Assets Abroad: Increase or
decrease in US ownership of foreign
financial assets.
• Foreign-Owned Assets in the US: Increase
or decrease in foreign ownership of
domestic assets.
• Reserve Assets: Primarily the assets of
central banks.

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 Balance of Payments
The Financial Sector
• Portfolio Investment: Individual or
business purchase of stocks, bond, or other
financial assets or deposits. (An income
strategy)
• Foreign Direct Investment: Purchase of
financial assets that results in a 10 percent
or greater ownership share. (A financial
control strategy)
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Capital and Financial Account
(2000)
Capital Account, Net 680
Financial Account
US-Owned Assets -553,349
Abroad
US Official Reserve Assets -290
US Government Assets -715
US Private Assets -552,344
Foreign-Owned Assets 952,430
Foreign Official Assets 35,909
Other Foreign Assets 916,521
Net Financial Flows 399,761

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 The Balance of Payments
The Statistical Discrepancy

Balance on Current Account -435,377

Capital Account, net 680

Net Financial Flows 399,081

Statistical Discrepancy 35,616

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International Allocation of
Capital
 Feldstein - Horioka
• Savings and Investment Relation
• Based on a closed economy income
condition:
y = c + i + g.
• Rearrange as:
y - c - g = i.

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 Feldstein - Horioka
• Rearranged as:
y - c - g = i.
• Note that y - c - g equals savings, s. Then:
s = i.
• In a closed economy, domestic investment is equal to
domestic saving by definition, but is also correlated in
practice, i.e., correlation coefficient is necessarily
close to 1 in value.

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 International Flow of Goods,
Services, & Capital
• Domestic Savings and Investment & NFF
National Income (GNY) = Consumption (C) +
Savings (S)
National Spending (GNE) = Consumption (C) +
Investment (I)
GNY - GNE = S - I
GNY - GNE = Exports (x) - Imports (m)
S-I=x-m
Net Foreign Investment = x - m

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Government Budget Deficits and
NFF
GNE = Household spending + Private I
+ Government spending
= GNY - Private S - Taxes + Private I
+ Government spending
GNE - GNY = Private (I - S) +
GovDeficit/Surplus
NFF = Private savings surplus - GovDeficit

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US Balance of Payments
 U.S. TRADE AND CURRENT ACCOUNT BALANCES
EXPRESSED AS A PERCENTAGE OF GDP

4%

2%

0% C/A
TB
-2%

-4%

-6%
46 50 54 58 62 66 70 74 78 82 86 90 94 98 2

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 Basic Premise

A current account deficit must be financed by

capital inflows, or it cannot be incurred in the
first place

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 FACT

Over 1982-2003, U.S. current

account deficits have averaged
$183 billion per year.
$4 trillion worth of assets have
been transferred to foreign
ownership.
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Trade and Scale Variables I

QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.

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 Scale Variables I
U.S. monthly GDP: $1 trillion
• Monthly goods and services exports: $130
billion = 13%
• Monthly goods and services imports: $185
billion = 18.5%
• Balancing item: net capital flow: $55 billion
= 5.5%

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 Scale Variables II
U.S. GDP per worker: $84,000 per
year
• Exports of $10,900 per year
• Imports of $15,500 per year

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 Result:
Foreign claims on U.S. assets
now exceed U.S. claims on
foreign assets by about $2.7
trillion.
–Storing up purchasing power for the future
–Private political risk insurance
–Public political risk insurance

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 International Investments
(market value, end-2003)
U.S. foreign investments: $7.9 trn
Foreign investments in U.S.: $10.5 trn
Net: -$2.7 trn

Much of this capital inflow has been portfolio

investment.
Some has been direct investment.
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 Foreign Direct Investment
(market value, end-2003)
U.S. DI abroad: $2.7 trillion
Foreign DI in U.S.: $2.4 trillion
Net: $0.3 trillion

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 Direct Investment Positions
At current market value, $ trillion

3.0
2.5

2.0

1.5 U.S. Direct Investment Abroad

1.0

0.5 Foreign Direct Investment in U.S.

0.0
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86 88 90 92 94 96 98 00 02 55
 US foreign direct investment, 2001

Asia,Pacific
11% Other
U.K.
2%
Japan 18%
5%

Caribbean
8%

L.America
12% Europe
34%
Canada
10%

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 Foreign direct investment in US, 2001

Japan
Other
12% UK
5%
16%
Caribbean
3%
Canada
8%

other
Europe
56%

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