International Finance – Theory into Practice - Hardcover

Sercu, Piet

Hardcover

ISBN 10: 069113667X ISBN 13: 9780691136677

Publisher: Princeton University Press, 2009

Synopsis

International Finance presents the corporate uses of international financial markets to upper undergraduate and graduate students of business finance and financial economics. Combining practical knowledge, up-to-date theories, and real-world applications, this textbook explores issues of valuation, funding, and risk management. International Finance shows how theoretical applications can be brought into managerial practice. The text includes an extensive introduction followed by three main sections: currency markets; exchange risk, exposure, and risk management; and long-term international funding and direct investment. Each section begins with a short case study, and each of the sections' chapters concludes with a CFO summary, examining how a hypothetical chief financial officer might apply topics to a managerial setting. The book also contains end-of-chapter questions to help students grasp the material presented. Focusing on international markets and multinational corporate finance, International Finance is the go-to resource for students seeking a complete understanding of the field. * Rigorous focus on international financial markets and corporate finance concepts * An up-to-date and practice-oriented approach * Strong real-world examples and applications * Comprehensive look at valuation, funding, and risk management * Introductory case studies and "CFO summaries," and end-of-chapter quiz questions * Solutions to the quiz questions are available online

About this title

About the Author

Piet Sercu is professor of international finance at the Catholic University of Leuven. He is the coauthor, with Raman Uppal, of "International Financial Markets and the Firm".

From the Back Cover

"This will become a classic of international finance."--Philippe Jorion, University of California, Irvine

"This book combines a rigor and practicality that few leading finance textbooks achieve. Once you have read it you will understand what matters in international finance, what does not, and how to deal with both."--Ian Cooper, London Business School

"I cannot think of a more comprehensive and more operationally relevant textbook than this one. Having read it, a student or practitioner is ready for operational work and duly prepared to avoid all the conceptual pitfalls commonly encountered on the international side of finance."--Bernard Dumas, University of Lausanne and Swiss Finance Institute

"This textbook employs modern finance in an international setting, all presented in the clearest, most stimulating way. In addition to each chapter being accompanied by a set of exercises, each part of the textbook is also nicely complemented by a case study. Comprehensive and up to date, the book covers everything from forward exchange rates, exchange risks, costs of international capital, and international taxation, to cross listings, swaps, and values at risk. There is no doubt this is the premier textbook for international finance."--Suleyman Basak, London Business School

"Piet Sercu's tour de force provides the most comprehensive treatment of major issues in international finance among all the books in the field. The author defines the key issues up front, tackles them in a coherent and focused manner, and strikes the right balance between basic concepts and practical applications. Readers can feel the pulse of world financial markets from the author's lively explanations of market mechanisms and conventions. Clear, entertaining, and up-to-date, this book sets a high standard for the study of international finance."--Cheol Eun, Georgia Institute of Technology

"Analytical and rigorous, International Finance presents fresh data, cohesively organized chapters, and timely issues."--G. Andrew Karolyi, Ohio State University

"This accessible and important book provides a big picture for corporate finance within the context of the international financial markets."--Karen K. Lewis, University of Pennsylvania

From the Inside Flap

"This will become a classic of international finance."--Philippe Jorion, University of California, Irvine

"This book combines a rigor and practicality that few leading finance textbooks achieve. Once you have read it you will understand what matters in international finance, what does not, and how to deal with both."--Ian Cooper, London Business School

"I cannot think of a more comprehensive and more operationally relevant textbook than this one. Having read it, a student or practitioner is ready for operational work and duly prepared to avoid all the conceptual pitfalls commonly encountered on the international side of finance."--Bernard Dumas, University of Lausanne and Swiss Finance Institute

"This textbook employs modern finance in an international setting, all presented in the clearest, most stimulating way. In addition to each chapter being accompanied by a set of exercises, each part of the textbook is also nicely complemented by a case study. Comprehensive and up to date, the book covers everything from forward exchange rates, exchange risks, costs of international capital, and international taxation, to cross listings, swaps, and values at risk. There is no doubt this is the premier textbook for international finance."--Suleyman Basak, London Business School

"Piet Sercu's tour de force provides the most comprehensive treatment of major issues in international finance among all the books in the field. The author defines the key issues up front, tackles them in a coherent and focused manner, and strikes the right balance between basic concepts and practical applications. Readers can feel the pulse of world financial markets from the author's lively explanations of market mechanisms and conventions. Clear, entertaining, and up-to-date, this book sets a high standard for the study of international finance."--Cheol Eun, Georgia Institute of Technology

"Analytical and rigorous, International Finance presents fresh data, cohesively organized chapters, and timely issues."--G. Andrew Karolyi, Ohio State University

"This accessible and important book provides a big picture for corporate finance within the context of the international financial markets."--Karen K. Lewis, University of Pennsylvania

Excerpt. © Reprinted by permission. All rights reserved.

International Finance

Theory into PracticeBy Piet Sercu

Princeton University Press

Copyright © 2009 Princeton University Press
All right reserved.
ISBN: 978-0-691-13667-7

Contents

Preface............................................................................xiAcknowledgments....................................................................xivI Introduction and Motivation for International Finance............................11 Why Does the Existence of Borders Matter for Finance?............................32 International Finance: Institutional Background..................................16II Currency Markets................................................................63About This Part....................................................................653 Spot Markets for Foreign Currency................................................694 Understanding Forward Exchange Rates for Currency................................1155 Using Forwards for International Financial Management............................1576 The Market for Currency Futures..................................................2027 Markets for Currency Swaps.......................................................2398 Currency Options (1): Concepts and Uses..........................................2629 Currency Options (2): Hedging and Valuation......................................299III Exchange Risk, Exposure, and Risk Management...................................337About This Part....................................................................33910 Do We Know What Makes Forex Markets Tick?.......................................34211 Do Forex Markets Themselves See What Is Coming?.................................39812 (When) Should a Firm Hedge Its Exchange Risk?...................................43413 Measuring Exposure to Exchange Rates............................................45414 Value-at-Risk: Quantifying Overall Net Market Risks.............................49315 Managing Credit Risk in International Trade.....................................530IV Long-Term International Funding and Direct Investment...........................551About This Part....................................................................55316 International Fixed-Income Markets..............................................55817 Segmentation and Integration in the World's Stock Exchanges.....................59518 Why-or When-Should We Cross List Our Shares?....................................64119 Setting the Cost of International Capital.......................................66320 International Taxation of Foreign Investments...................................70321 Putting It All Together: International Capital Budgeting........................73922 Negotiating a Joint-Venture Contract: The NPV Perspective.......................777Further Reading....................................................................801References.........................................................................803Index..............................................................................813

Chapter One

Why Does the Existence of Borders Matter for Finance?

Almost tautologically, international finance selects from the broad field of finance those issues that have to do with the existence of many distinct countries. The fact that the world is organized into more or less independent entities instead of a single global state complicates a chief financial officer's (CFO's) life in many ways—ways that matter far more than does the existence of provinces or states or Landen or départements within a country. Below, we discuss

• the existence of national currencies and, hence, the issue of exchange rates and exchange risk;

• the segmentation of goods markets along predominantly national lines; in combination with price stickiness, this makes most exchange-rate changes "real";

• the existence of separate judicial systems, which further complicates the already big issue of credit risk, and has given rise to private-justice solutions;

• the sovereign autonomy of countries, which adds political risks to standard commercial credit risks;

• the existence of separate and occasionally incompatible tax systems, giving rise to issues of double and triple taxation.

We review these items in section 1.1. Other issues or sources of problems, such as differences in legal systems, investor protection, corporate governance, and accounting systems, are not discussed in much depth, not because they are irrelevant but for the simple reasons that there is too much heterogeneity across countries and I have no expertise in them. Still, in chapters 17 and 18 there are sections that should create a basic awareness in these issues, so that the reader can then critically look at the local regulation and see its relative strengths and weaknesses.

The above list includes some of the extra issues a CFO in an international company needs to handle when doing the standard tasks of funding, evaluation, and risk management (section 1.2). The outline of how we will work our way through all this material follows in section 1.3.

1.1 Key Issues in International Business Finance

1.1.1 Exchange-Rate Risk

Why do most countries have their own money? One disarmingly simple reason is that printing bank notes is profitable, obviously, and even the minting of coins is usually a positive net present value (NPV) business. In the West, at least since the days of the Greeks and Romans, governments have been involved as monopoly producers of coins or at least as receivers of a royalty ("seignorage") from the use of the official logo. More recently, the ascent of paper money, where profit margins are almost too good to be true, has led to official monopolies virtually everywhere. One reason why money production is not handed over to the United Nations (UN) or the International Monetary Fund (IMF) or World Bank is that governments dislike giving up their monopoly rents. For instance, the shareholders of the European Central Bank (ECB) are the individual euro countries, not the European Union (EU) itself; that is, the countries have given up their monetary independence, but not their seignorage. In addition, having one's own money is a matter of national pride too: most Britons or Danes would not even dream of surrendering their beloved pound sterling or crown for, of all things, a European currency. Lastly, a country with its own money can adopt a monetary policy of its own, tailored to the local situation. Giving up a local policy was a big issue at the time the introduction of a common European currency was being debated.

If money had intrinsic value (e.g., a silver content), if that intrinsic value were stable and immediately obvious to anybody, and if coins could be de-minted into silver and silver re-minted into coins at no cost and without any delay, then the value of a German joachimsthaler relative to a Dutch florin and a Spanish real would all be based on their relative silver content, and would be stable. But in practice many sovereigns were cheating with the silver content of their currencies, and got away with it in the short run. Also, there are costs in identifying a coin's true intrinsic value and in converting Indian coins, say, into Moroccan ones. Finds of hoards dating from Roman or medieval times reveal astounding differences in the silver content of various coins with the same denomination. For instance, among solidus pieces from various mints and of many vintages, some have silver contents that are twice that of other solidus coins found in the same hoard. In short, intrinsic value never did nail down the market value in a precise way, not even in the days when coins really were made of silver, and as a result exchange rates have always fluctuated. Since the advent of paper money and electronic money, of course, intrinsic value no longer exists: the idea that paper money was convertible into gold coins lost all credibility after World War I. After World War II, governments for some time controlled the exchange rates, but largely threw in the towel in 1973-74. Since then, exchange rates are based on relative trust, a fickle good, and the resulting exchange-rate risk is a fact of life for all major currency pairs.

Exchange risk often implies that there is contractual exposure: there is uncertainty about the value of any asset or liability that expires at some future point in time and is denominated in foreign currency. But exchange risk also affects a company's financial health via another channel—an interaction, in fact, with another international issue: segmentation of consumer-goods markets.

1.1.2 Segmentation of Consumer-Goods Markets

While there are true world markets—and, therefore, world prices—for commodities, many consumer goods are really priced locally, and for traditional services international influence is virtually absent. Unlike corporate buyers of say oil or corn or aluminum, private consumers do not bother to shop around internationally for the best prices: the amounts at stake are too small, and the transportation cost and hassle and delay from international trade would be prohibitive anyway. Distributors, who are better placed for international shopping around, prefer to pocket the resulting quasi-rents themselves rather than passing them on to consumers. For traditional services, international trade is not even an option. So prices are not homogenized internationally even after conversion into a common currency. One strong empirical regularity is that, internationally, prices rise with GDP per capita. In figure 1.1, for instance, you see prices of the Big Mac in various countries, relative to the U.S. price. Obviously, developed countries lead this list, with growth countries showing up as less expensive by the Economist's Big Mac standard. The ratio of Big Mac prices in Switzerland to those in China is 3.80. In early 2006, Norway was more than five times as expensive as China; and two years before, the gap between Iceland and South Africa was equally wide.

Within a country, by contrast, there is less of this price heterogeneity. For example, price differences between "twin" towns that face each other across the borders between the United States and Canada or between the United States and Mexico are many times larger than differences between East- and West-Coast towns within the United States. One likely reason that contributes to more homogeneous pricing within a country is that distributors are typically organized nationally. Of course, the absence of hassle with customs and international shippers and foreign indirect tax administrations also helps.

A second observation is that prices tend to be sticky. Companies prefer to avoid price increases, because the harm done to sales is not easily reversed: consumers are resentful, or they just write off the company as "too expensive" and do not even notice when prices come down again. Price decreases, on the other hand, risk setting off price wars, and so on.

Now look at the combined picture of (i) price stickiness, (ii) lack of international price arbitrage in consumption-goods markets, and (iii) exchange-rate fluctuations. The result is real exchange risk. Barring cases of hyperinflation, short-run exchange-rate fluctuations have little or nothing to do with the internal prices in the countries that are involved. So the appreciation of a currency is not systematically accompanied by falling prices abroad or soaring prices at home so as to keep goods prices similar in both countries. As a result, appreciation or depreciation can make a country less attractive as a place to produce and export from or as a market to export to. They therefore affect the market values and competitiveness of companies and economies, that is, economic exposure. For instance, the soaring USD in the Reagan years has meant the end of many a U.S. company's export business, and the rise of the DEM in the 1970s forced Volkswagen to become a multicountry producer.

Real exchange risk also affects asset values in a more subtle way. Depending on where they live, investors from different countries realize different real returns from one given asset if the real exchange-rate changes. Thus, one of the fundamental assumptions of, for example, the capital asset pricing model (CAPM)—that investors all agree on the returns and risks of all assets—becomes untenable. While this may sound like a very theoretical issue, it becomes more important once you start thinking about capital budgeting. For instance, a U.S. firm may be considering an investment in South Africa, starting from projected cash flows in South African rand (SAR). How to proceed? Should the managers discount them using a SAR discount rate, the way a local investor would presumably do it, and then convert the present value into USD using the current spot rate? Or should they do it the U.S. way: use expected future spot rates to convert the data into expected USD cash flows, to be discounted at a USD rate? Should both approaches lead to the same answer? Can they, in fact?

Exchange risk is the issue that takes up more space than any other separate topic in this book. Its importance can be seen from the fact that so many instruments exist that help us cope with this type of uncertainty: forward contracts, currency futures and options, and swaps. You need to understand all these instruments, their interconnections, their uses and limitations, and their risks.

1.1.3 Credit Risk

If a domestic customer does not pay, you resort to legal redress, and the courts enforce the ruling. Internationally, one problem is that at least two legal systems are involved, and they may contradict each other. Usually, therefore, the contract will stipulate what court will rule and on the basis of what law—say Scottish law in a New York court (I did not make this up). Even then, the new issue is that this court cannot enforce its ruling outside its own jurisdiction.

This has given rise to private-contract solutions: we seek guarantees from specialized financial institutions (banks, factors, insurance companies) that (i) are better placed to deal with the credit risks we shifted toward them, and (ii) have an incentive to honor their own undertakings because they need to preserve a reputation and safeguard relations with fellow banks, etc. So you need to understand where these perhaps Byzantine-sounding payment options (such as D/A, D/P, L/C without or with confirmation, factoring, and so on) come from, and why and where they make sense.

1.1.4 Political Risk

Governments that decide or rule as sovereigns, having in mind the interest of their country (or claiming to have this in mind), cannot be sued in court as long as what they do is constitutional. Still, these decisions can hurt a company. One example is imposing currency controls, that is, blocking some or all exchange contracts, so that the money you have in a foreign bank account gets stuck there, that is, transfer risk. You need to know how you can react pro- and retroactively. You also need to know how this risk must be taken into account in international capital budgeting. If and when your foreign-earned cash flow gets stuck abroad, it is obviously worth less than its nominal converted value because you cannot spend the money freely where and how you want—but how does one estimate the probabilities of this happening at various dates, and how does one predict the size of the value loss?

Another political risk is expropriation or nationalization, overtly or by stealth. While governments can also expropriate locally owned companies (like banks, as in France in 1981), foreign companies in the "strategic" sectors (energy, transportation, mining and extraction, and, flatteringly, finance) are especially vulnerable: most of them were expropriated or had to sell to locals in the 1970s. The 2006 Bolivian example, where President Evo Morales announced that "The state recovers title, possession and total and absolute control over [our oil and gas] resources" (Economist, May 4, 2006), also has to do with such a sector. Again, one issue for the finance staff is how to factor this into NPV calculations.

1.1.5 Capital-Market Segmentation Issues, Including Aspects of Corporate Governance

A truly international stock and bond market does not exist. First, while stocks and bonds of big corporations do get traded in many places and are held by investors all over the world, mid-size or small-cap companies are largely one-country instruments. Second, portfolios of individual and institutional investors exhibit strong home bias—that is, heavy overweighting of local stocks relative to foreign stocks—even regarding their holdings of shares in large corporations. A third aspect of fragmentation in stock markets is that we see no genuine international stock exchanges (in the sense of institutions where organized trading of shares takes place); instead, we have a lot of local bourses. A company that wants its shares to be held in many places gets a listing on two or three or more exchanges (dual or multiple listings; cross listing): being traded in relatively international places like London or New York is not enough, apparently, to generate worldwide shareholdership. How come?

The three phenomena might be related, and caused by the problem of asymmetric information and investor protection. Valuing a stock is more difficult than valuing a bond, even a corporate bond, and the scope for misrepresentation is huge, as the railroad and dot-com bubbles have shown. All countries have set up some legislation and regulation to reduce the risks for investors, but there are enormous differences in the amount of information, certification, and vetting required for an initial public offering (IPO). All countries think, or claim to think, that other countries are fools by imposing so much/little regulation. The scope for establishing a common world standard in the foreseeable future is nil. Pending this, there can be no single world market for stocks.

The same holds for disclosure requirements once the stock has been launched, and the whole issue of corporate governance. The big issue here is how to avoid managers self-dealing or otherwise siphoning off cash that ought to belong to the shareholders. Good governance systems contain checks and balances: separation of the jobs of chairman of the board of directors and chief executive officer (CEO); a sufficient presence of independent directors on the board; an audit committee that closely watches the accounts; comprehensive information provision for investors; a willingness, among the board members, to fire poorly performing CEOs, perhaps on the basis of preset performance criteria; a board that can be fired by the assembly general meeting in one shot (as opposed to staggered boards, where every year only one fifth comes up for (re)election, for example); and an annual general meeting that can formulate binding instructions for the board and the CEO. Good governance also requires good information provision, with detailed financial statements accompanied by all kinds of qualitative information.

(Continues...)

Excerpted from International Financeby Piet Sercu Copyright © 2009 by Princeton University Press. Excerpted by permission of Princeton University Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Edition details

• Publisher: Princeton University Press
• Publication date: 2009
• Language: English
• ISBN 10: 069113667X
• ISBN 13: 9780691136677
• Binding: Hardcover
• Number of pages: 832