What is International Finance

Business and Economics

International Finance
Associate Professor Elaine Hutson

Business and Economics

Lecture 1: What is IF? Current
multinational financial challenges, and
ownership and governance of the company

Readings for this week

From Eiteman, Stonehill and Moffett:
Chapters 1 and 2
Additional readings (available on the library reading list):
1. “The endangered public company: the rise and fall of a great invention, and
why it matters” The Economist May 19th, 2012.
2. “The endangered public company: the big engine that couldn‟t” The
Economist May 19th, 2012.
3. “Anything you can do, Icahn do better” The Economist February 15th, 2014.

3

What is international finance?

4

What is international finance?
1.

The international macroeconomic environment; in particular
– Exchange rate systems
– Exchange rate determination

2.

International (or foreign) portfolio investment (FPI)

3.

International financial management (or international corporate
finance)
– let‟s look at the elements of (domestic) corporate finance…

5

Corporate finance
the investment
decision

the financing
decision
the dividend
decision

6

Corporate finance
the investment
decision

the financing
decision

financial risk
management
decisions

the dividend
decision

7

The investment decision
 What real assets to invest in?
 You have learned the basics of capital budgeting –
discounting, NPV, IRR etc.
 Investment in real assets include greenfield investments,
joint ventures, and mergers and acquisitions.

8

The financing decision
 Debt/equity mix (capital structure)
 What sort of debt?
– bank (intermediated) or public (direct)?
– term (or maturity)?
– fixed or variable rate of interest? (interrelation with
risk management decision)

9

The financing decision
 What sort of equity?
– Family/friends
– Angel financing
– Venture capital/private equity
– Initial public offering (IPO)
– Seasoned issues

10

Financial risk management decisions
 Main (domestic) financial risks are:
– Interest rate risk
– Commodity price risk

11

International financial management
When we study domestic corporate finance we tend to bypass international issues:
ID

 Real investment abroad: Foreign direct investment (FDI)
– Different regulatory systems, legal systems and tax
regimes; different systems of corporate governance;
political risks

FD

 Internationalisation of financial markets – finance can be
sourced globally

RMD

 Exchange rate exposure/risk.

12

What we do in AFC3240 International
Finance
1
What is IF/IFM? Current
2
3
4
5

6
7
8
9
10
11
12

multinational financial challenges,
and ownership and governance of
the company
The international monetary system
The balance of payments
The US and European financial
crises
The foreign exchange market, and
international parity conditions, part 1
– purchasing power parity
International parity conditions, part 2
– interest rate parity
Mid-semester test
The determinants of exchange rates
Currency derivatives
Transaction exposure management
Operating exposure management
International portfolio theory
13

What we do in AFC3240 International
Finance
1
What is IF/IFM? Current
Exchange rate
systems

2
3
4
5

6
7
8
9
10
11
12

multinational financial challenges,
and ownership and governance of
the company
The international monetary system
The balance of payments
The US and European financial
crises
The foreign exchange market, and
international parity conditions, part 1
– purchasing power parity
International parity conditions, part 2
– interest rate parity
Mid-semester test
The determinants of exchange rates
Currency derivatives
Transaction exposure management
Operating exposure management
International portfolio theory
14

What we do in AFC3240 International
Finance
1
What is IF/IFM? Current
Exchange rate
systems
Exchange rate
determination

2
3
4
5

6
7
8
9
10
11
12

multinational financial challenges,
and ownership and governance of
the company
The international monetary system
The balance of payments
The US and European financial
crises
The foreign exchange market, and
international parity conditions, part 1
– purchasing power parity
International parity conditions, part 2
– interest rate parity
Mid-semester test
The determinants of exchange rates
Currency derivatives
Transaction exposure management
Operating exposure management
International portfolio theory
15

What we do in AFC3240 International
Finance
1
What is IF/IFM? Current
Exchange rate
systems
Exchange rate
determination
Foreign
exchange risk
management

2
3
4
5

6
7
8
9
10
11
12

multinational financial challenges,
and ownership and governance of
the company
The international monetary system
The balance of payments
The US and European financial
crises
The foreign exchange market, and
international parity conditions, part 1
– purchasing power parity
International parity conditions, part 2
– interest rate parity
Mid-semester test
The determinants of exchange rates
Currency derivatives
Transaction exposure management
Operating exposure management
International portfolio theory
16

What we do in AFC3240 International
Finance
1
What is IF/IFM? Current
Exchange rate
systems
Exchange rate
determination
Foreign
exchange risk
management
FPI

2
3
4
5

6
7
8
9
10
11
12

multinational financial challenges,
and ownership and governance of
the company
The international monetary system
The balance of payments
The US and European financial
crises
The foreign exchange market, and
international parity conditions, part 1
– purchasing power parity
International parity conditions, part 2
– interest rate parity
Mid-semester test
The determinants of exchange rates
Currency derivatives
Transaction exposure management
Operating exposure management
International portfolio theory
17

AFC3240 International Finance
 Few of the issues in International Finance are set in stone; that is, for
some questions there are no right or wrong answers.
 In exchange rate systems and exchange rate determination you will
learn about the principal theories, but the extent to which the reality fits
the theory is mixed, and how theory and principles guide practice is
subject to debate.
For example,
– To what extent do the theories of exchange rate determination
explain recent movements in exchange rates?

– How do policymakers decide on what exchange rate system to
use?

18

AFC3240 International Finance
 Few of the issues in International Finance are set in stone; that is, for
some questions there are no right or wrong answers.
 In exchange rate risk management, you will learn useful principles and
theory, but there is a lot that we don‟t completely understand about
exchange rate risk management, such as
– The extent to which firms apply these principles.
– What types of firms are most exposed to exchange rate
movements.
– How firms should optimally manage exchange rate risk.

19

Teaching approach
 The lectures will not always closely follow the text.
 In lectures, I prefer to introduce the topics, present and explain the
more complex topics, and discuss current events and recent empirical
or other evidence.
 ESM is a very good, easy-to-read text.
– You can read it by yourself; you don‟t need me to take you
through it line-by-line.
 The tutorial questions will usually involve a mix of content referred to in
the lectures (such as those relating to additional readings) and from
the text.

 I encourage you to read, think, and then to analyse, evaluate and
make conclusions about the various topics and questions yourselves.

20

Some definitions

21

Some definitions: Types of traders
 Investors: We define investors as traders who buy assets with a view to
holding them for the medium to long-term.
 Speculators: traders who enter markets and take risky positions for the
purpose of gaining a short-term profit.
 Hedgers: Unlike speculators and investors who take risk, hedgers are
traders who are in the market with a view to reducing or eliminating risk.
 Arbitrageurs: Arbitrageurs are people who engage in arbitrage trades.
Arbitrage is the act of simultaneously buying and selling equivalent
assets for the purpose of making certain, guaranteed profits. An
arbitrage trade is a risk-free trade.

22

Some definitions:  Types of markets


Formal exchanges: organised „places‟ for trading assets (eg
stock exchanges and futures exchanges) that have formal
listing and trading rules.



OTC (over-the-counter) markets: any other markets, formal
or informal. Trading is facilitated by telephone and automated
dealing systems.

23

Some definitions:  Types of trade
facilitators


Broker
• A broker organises the trade, by „introducing‟ the buyer to the seller and
the seller to the buyer.
• Brokers do not hold a position in the asset, and the transaction is between
the seller and the buyer.
• The broker charges a commission for this service.



Dealer (they hold stock/inventory. They are actually trading)
• A dealer acts as a buyer to the seller and a seller to the buyer, and holds
stocks of the asset.
• The dealer earns the dealer’s spread, buy buying at a slightly lower price
than what they sell at.
24

Chapter 1 of ESM
Current multinational financial challenges

25

Currency market basics

26

Forward and spot markets
 The spot foreign exchange (forex)
market is for immediate delivery.
 The forward forex market involves
agreements to buy and sell
currencies at prices agreed on
today for delivery at a specified
time in the future.

Data source:

 Banks quote for 1, 3, 6, 9, and 12
month maturities are readily
available for forward contracts; but
can be anything from a few days to
up to 10 years.

http://www.bis.org/publ/rpfx13.htm

27

Exchange rate/currency symbols
There is a standardised system
of three-letter codes to denote
particular currencies.

For example:
Australian dollar:

AUD

US dollar:

USD

Chinese yuan:

CNY

British pound:

GBP

Euro:

EUR

28

Exchange rate/currency symbols
There is a standardised system
of three-letter codes to denote
particular currencies.

For example:

I will refer to the US dollar as the
dollar, and the Australian dollar
as the Aussie.
I will also use the following
symbols:

Australian dollar:

AUD

A$

US dollar:

USD

$

Chinese yuan:

CNY

¥

British pound:

GBP

£

Euro:

EUR

€

29

What is an exchange rate?

 Simply the price of one currency in terms of another.
 23rd July 2014 (www.x-rates.com):

– AUD versus USD 0.942825 or 1.060642
– AUD versus CNY 5.848512 or 0.170984
– EUR versus USD 0.742629 or 1.346568

30

Quoting exchange rates: direct and indirect

 The home / base currency must be clarified.
Where are you?
 Direct: the domestic currency price of foreign currency, or how much
domestic currency does it take to buy 1 unit of foreign currency?
 Indirect: the foreign currency price of domestic currency, or how
much foreign currency does it take to buy 1 unit of domestic
currency?
 The exchange rate symbol used in the text (and that we will use) is S.

31

Quoting exchange rates: direct and indirect

S(A$/€) = 1.428137

How many
Aussies

To one
euro

S(€/A$) = 0.700213

How many
euro

To one
Aussie

This is a direct quote from an
Australian perspective (or an
indirect quote from a
Eurozone perspective).

This is an indirect quote from an
Australian perspective (or a direct
quote from a Eurozone
perspective).

32

Recent trends in international trade,
investment and financial markets

33

Trends in international trade and investment:
the last 30-40 years
 Globalisation in trade and FDI:
• Freeing up of world trade (GATT, WTO)
• Reduction of barriers to FDI

34

Total value of exports, 1980-2010

Data source: UNCTADstat
35

Merchandise exports

Data source: UNCTADstat
36

Services exports

Data source: UNCTADstat
37

Capital flows: FDI

Data source: UNCTADstat
38

Trade and capital flows: Openness to trade and FDI
200
180

percentage of GDP

160
FDI openness
140

trade openness

120
100
80
60
40
20

U
S
Ja
pa
n

Be
lg
iu
m
Ire
N
et lan
he d
rla
nd
A s
us
tr
N ia
or
w
M ay
ex
Po ico
r
Sw tu g
itz al
er
la
Sw nd
ed
Ca en
n
D ada
en
m
a
Fi rk
nl
an
d
N
ew U
Ze K
al
a
Tu nd
rk
G ey
er
m
an
G y
re
ec
e
Ita
ly
Sp
ai
Fr n
an
A ce
us
tra
lia

0

This figure plots the FDI and trade openness ranked (left to right) on trade openness. The figures for trade openness
were obtained from Penn World Table Version 6.1, for the period 1984-2000 (from Alan Heston, Robert Summers
and Bettina Aten, Penn World Table Version 6.1, Center for International Comparisons at the University of
Pennsylvania (CICUP)) (http://pwt.econ.upenn.edu/php_site/pwt61_form.php), and the figures for FDI are inward
plus outward stock of FDI as at 2003 (from UNCTAD’s 2005 World Investment Report) standardised by GDP.

39

Trends in international financial markets:
the last 30-40 years
 Market volatility:
•

Exchange rates – the end to the Bretton Woods system of fixed
exchange rates (early 1970s)

•

Interest rates – relaxation of bank regulation and growth of
indirect debt markets

 Globalisation:
•

Removal of capital controls (capital control = limit of movement
of capital/money across borders)
• Almost exponential increase in capital flows – mainly
speculative (as well as FDI and FPI)

 The rise of derivatives:
•

Designed to manage risks, but have they become “weapons of
mass destruction”?
40

International capital flows: forex market turnover
2013 BIS triennial survey of foreign exchange activity, April 2013
 average daily turnover of $5.3 trillion a day, compared to $4.0 trillion in 2010
and $3.2 trillion in 2007
Data source:

http://www.bis.org/publ/rpfx13.htm

41

The multinational company (MNC)
and international business

42

The multinational company (MNC)

 The last part of Chapter 1 looks at the MNC.
 However, many (most?) firms now
 Face international competitive pressures and international
economic risks
 Want to seek international markets, outsource/offshore
activities to other countries, and/or import from abroad
 Are exposed to exchange rate risk
 All business is international in the 21st century.

43

Theories of international business (IB)
 There are two areas of IB theory discussed in
chapter 1.
– The first relates to the question of why firms
internationalise
– The second relates to the process of
internationalisation or globalisation

44

Theories of international business (IB):
why do firms internationalise?
 This theory is usually couched as theories of FDI – why do
firms invest in real assets abroad?

1.
2.
3.
4.
5.

Market-seeking
The search for raw materials (raw materials-seeking)
Production efficiency seeking (e.g. Cheap labour seeking)
Knowledge-seeking
Political safety seekers

45

Theories of international business (IB):
the process of internationalisation

 Standard theories of internationalisation see it as a gradual
process – carefully sequenced
– Moving from exporting (lowest risk),
– to licensing and/or joint ventures,
– and then finally FDI (highest risk; highest return)

46

Theories of international business (IB):
the process of internationalisation
 These standard theories have been challenged; notably by what is
known as the INV – international new venture (also called born
global firms)
– INVs export or have international partners or manufacture
abroad right from the start
 Start-up firms are more likely to be INVs (rather than operate purely
domestically) when they are
– Based in small countries
– In niche/specialist markets

47

Recent trends in international business
 Increasingly, firms are engaging in international sourcing of inputs
to the production process.

 Offshoring and foreign outsourcing
 Many firms have global supply chains.
– See example of the Boeing 787 Dreamliner on next page…

 Offshoring and foreign outsourcing also occurs in services.

48

Fragmentation of production and global supply chains

Source:
http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/TRADE/0,,contentMDK:22894003~menuPK:2644066~pagePK:64020865~piPK:51164185~theSitePK:239071,00.html

49

Chapter 2 of ESM
Ownership and governance of the corporation

50

Business entity structures
Public
(SOEs)

Private

51

Business entity structures
Public

Private

(SOEs)

Wholly stateowned

Partially
publicly traded

Publicly traded

Private
company

52

Business entity structures
Public

Private

(SOEs)

Wholly stateowned

Partially
publicly traded

Publicly traded

Private
company

Three reasons for the rise and long-lasting success of the publicly traded private
corporation:
1. Limited liability
2. Professional management
3. „Corporate personhood‟
53

Business entity structures
Public

Private

(SOEs)

Wholly stateowned

Partially
publicly traded

Publicly traded

Private
company

•

UNCTAD defines a SOE(state owned enterprises) as a company in which
the state owns >10% of shares.

•

Some are wholly state-owned; most are publicly traded.

•

An important feature of emerging nations in particular.

54

Business entity structures
Public

Private

(SOEs)

Wholly stateowned

Partially
publicly traded

Publicly traded

Private
company

The publicly traded private company appears to be in decline. The first two
additional readings are about this issue.
But before we get to this, we need to discuss the two main models of
corporate governance…
55

Systems of corporate governance
Corporate governance relates to how companies are directed
and controlled.
 Listed companies involve some degree of separation of
ownership and control.
 In general, there are two basic models:
1. Shareholder wealth maximisation model
– This is the corporate governance system in Britain, US,
Australia….
– Sometimes called the „Anglo-Saxon‟ or „Anglo-American‟
model of corporate governance.

56

Systems of corporate governance
Shareholder wealth maximisation model
 Typical features:

– Dispersed shareholdings.
– Investors do not intervene in the day-to-day operations of the company.
– Most important corporate governance issue: how to ensure that
managers as agents of the shareholders act in shareholders‟ interest.
•

Referred to as agency problems or agency issues.

– The Board of Directors represents shareholders.
– There is a lot of regulation relating to the protection of shareholders.
– Takeovers, including hostile takeovers, are common.
– Usually associated with well-developed and highly liquid equity markets.

57

Systems of corporate governance
2.

Corporate wealth maximisation model

 Maximise „corporate‟ wealth, including stakeholders other than
shareholders.

 This is the traditional form of corporate governance on mainland
Europe – sometimes called the „European model‟.
 Typical features:
– Ownership and control is often inter-linked; investor intervention
in management is typically via controlling shareholders:
•

Controlling shareholders, eg banks in Germany, families in France,
Italy and parts of East Asia, government in China, Russia and
Brazil.

58

Systems of corporate governance

2.

„Corporate wealth maximisation model‟

 By definition, if there is a controlling shareholder there are also
minority shareholders.

– Minority shareholders are often not well protected.
 Ownership changes are infrequent; takeovers are very rare.

59

Publicly traded

“The endangered public company”

The article “The endangered
public company: the big engine
that couldn‟t” is mainly about
the apparent demise of the US
publicly listed private company
(the public company).

Source: “The endangered public
company: the big engine that
couldn‟t” The Economist, May 19th
2012.

Why companies prefer to be a
private company?

60

Publicly traded

“The endangered public company”
The number of public
companies in the US has
declined 38 percent in the US
and 48 percent in Britain since
1997.
Why?

1. Fewer IPOs

Source: “The endangered public
company: the big engine that
couldn‟t” The Economist, May
19th 2012.

2. Increase in delistings:
takeovers, private equity
buyouts(private buy public to
make it private).
•

Why?
61

Publicly traded

“The endangered public company”
Increase in delistings: M&A,
private equity buyouts
What does „private equity deal‟ or
„private equity buyout‟ mean?
What is their „business model‟?\

Source: “The endangered public
company: the big engine that
couldn‟t” The Economist, May 19th
2012.

Private equity acquire private
firms or division from existing
firms, delist them and keep them
private for a few years, then
refloat them again in the public
62

Publicly traded

“The endangered public company”

Why the massive decline in the number of US listed
companies and IPOs?
1. Agency costs
2. Regulation – particularly the Sarbanes Oxley Act 2002

3. Rising shareholder activism
(These three explanations are highly interrelated.)
4. Rise of alternative corporate forms

63

Publicly traded

“The endangered public company”

The importance of a vibrant IPO market
1. Facilitate innovation and entrepreneurship
• The alternative to a stock market listing for young
innovative companies is to sell to an established
company.
2. The private equity business relies on the ability to „re-float‟
companies.

64

Publicly traded

“The endangered public company”

The importance of the existence of public companies
1. Facilitate widespread participation in business ownership –
gives „ordinary people a chance to invest directly in
capitalism‟s most important wealth-creating machines‟.
2. Because we know a lot about them, „Public companies let in
daylight‟. In contrast, „private companies and family firms
operate in a fog of secrecy.‟

65

Publicly traded

Shareholder activism

 Who are the activists? Shareholders who harasses managers to
make changes
 What do they want?
– Changes to how companies are run; mostly related to
corporate governance, eg
• Split dual CEO/Chairman roles
• Changes to how directors are elected
– Very common these days: demands to hand over hoarded
cash to shareholders.

 A common criticism: incentivises managers to „do things that boost
their share price in the short run but harm their long-term
performance‟.

Reading: “Anything you can do, Icahn do better” The Economist February 15th, 2014.
66

Publicly traded

Shareholder activism

A paper cited in the article: Lucian Bebchuk, Alon Brav and Wei Jiang,
“The long-term effects of shareholder activism”:
 Examines all 2,040 interventions by activist hedge funds during the
period 1994-2007. Findings:
– No evidence that interventions are followed by declines in operating
performance in the long term; rather, activist interventions are followed by
improved operating performance during the following five years.
– No evidence that an initial positive stock price spike reverses over the
longer-term; the data are consistent with the initial spike reflecting
correctly the intervention‟s long-term consequences.

Reading: “Anything you can do, Icahn do better” The Economist February 15th, 2014.
67

Publicly traded

IPO boom!

The Economist January 11th 2014
222 IPOs in 2013 – a sevenfold increase relative to 2008.
Why?

68