Chapter 1: globalization & the multinational firm
Why study international finance?
The world economy is highly globalized and increasingly integrated in:
ð The markets for goods and services → consumption & production of goods & services.
ð The financial markets → allows investors to diversify investment portfolios internationally.
Today, all the major economic functions are globalized:
ð Consumption.
ð Production.
ð Investment.
What’s special about international finance?
4 major dimensions: set international finance apart from domestic finance.
1) Foreign exchange risk
2) Political risks (ex. decisions made by Trump, war between Ukrain & Russia)
3) Market imperfections
4) Expanded opportunity set (expand your company)
These are largely because sovereign nations have the right to issue currencies, formulate their own economic
policies, impose taxes, and regulate movements of people, goods, and capital across their borders.
1. Foreign exchange risk
Foreign exchange risk: stems from uncertain future exchange rates.
ð For example: profits made in a foreign currency may disappear once converted into the domestic
currency due to unanticipated exchange rate movements.
ð Exchange rates among major currencies (ex U.S. dollar, Japanese yen, British pound, and euro) fluctuate
continuously in an unpredictable manner.
ð Exchange rate uncertainty influences all major economic functions, including consumption, production,
and investment.
Example: if you are a US international company and you make 1.000.000 YEN in Japan, but the YEN deprecia-
ted so you lost some money from converting your profit from YEN to Dollar.
3 major currencies in the world: USD (takes up 60% of all currencies around the world), Euro (20% of all
international reserves), Chinese YUAN (CNY and CNH for being traded in China and HongKong).
ð All these currencies fluctuate, depending on the arrangements.
1
,Hawkish: restrictive = quantitative tightening.
ð Quantitative tightening: central banks ensure that a smaller amount of money circulates in the economy.
ð They try to raise interest rates, reduce the money supply, and sell government bonds (by the central
bank).
ð This helps them fight inflation and strengthen their currency (a higher interest rate makes the yen more
attractive).
ó Dovish policy: expansionary = quantitative easing.
ð Lowering interest rates, increasing the money supply, and the central bank buys government bonds, so
the government receives cash.
ð Investing in Japan is beneficial for European and American countries due to this hawkish policy.
Example: suppose $1 = ¥100 today, and you invest $1,000 to buy 50 shares of Toyota at ¥2,000 per share. One
year later, the share price has increased by ten percent, and your investment is worth ¥110,000. If the yen has
depreciated to $1 = ¥120 by that time, how much is your investment worth in dollar terms?
ð Initial investment in dollars: $1,000.
ð Initial investment in yen: $1,000 × (¥100/$) = ¥100,000.
ð Maturity value in yen: ¥110,000 (after 10% increase).
ð Maturity value in dollars: ¥110,000 / (¥120/$) = $916.67.
Answer:
ð Disturbing: the way that currencies are stated on the internet.
ð 10% appreciation yen, 20% depreciation dollar, so you loose 10%? No.
ð If you have a 10% depreciation you need more than 10% to bring it back up.
ð What would be the return of the investment? Return = (The new price – the old price)/ the old price
ð Pt-1 = 1000 USD
ð Pt = 916,67 USD
ð Return USD = (916,67 – 1000)/1000 =-0,0833
ð Pt-1 = 100 000 YEN
ð Pt = 110 000 YEN
ð Return YEN = (110000 – 100000)/100000 =0,1
Loss: because of depreciation of the yen.
ð It’s a floating market, because it changes all the time.
ð If the central bank is dovish so they lower interest rates, it pushes down the value of the currency
because you earn less money when holding the yen.
ð You receive less interest because of the lower interest rates.
2
, You have the value of the YEN in USD, always look
at what the Y axe is.
If it’s going up, then you need more YEN by one
dollar.
Appreciation of the USD, depreciation of the
USD.
If you want more purchasing power, go to Japan,
it will be cheaper there.
This is the percentage change, so this means that
the YEN depreciated by 30% from the level it was
the year before.
The depreciation was fast and strong over a short
time period.
Extra information on decpreciation & devaluation:
ð A depreciation is not a devaluation.
ð Devaluation or depreciation means a chance of higher inflation because imports are more expensive.
o Export is cheaper.
Depreciation - Happens because of market forces.
- Is about supply & demand.
- For example: a decline in foreign investments in Japan.
- Happens in a floating exchange rate environment.
Devaluation - Is a discretionary choice made by the monetary authorities.
- Imports will be more expensive & exports will be cheaps (both cases = case of deva-
luation & depreciation).
- Typically in a fixed exchange rate environment.
- The value of the currency is linked to another currency.
3
, What is a “carry trade”: it is an investment strategy in which an investor borrows money in a currency with a
low interest rate and invests it in a currency or asset with a higher interest rate.
ð The goal is to profit from the difference between the low borrowing rate and the higher return on the
investment.
ð For example: if interest rates in Japan are low (e.g., 0.5%) and rates in Australia are higher (e.g., 5%), an
investor could borrow Japanese yen at the low rate, exchange them for Australian dollars, and invest in
Australian bonds to earn the higher interest rate.
ð The profit comes from the interest rate differential, as long as exchange rates remain stable.
Borrowing cheap money in Japan and convert that money in USD to then invest in the US. Then when you have
the interest on your money, you convert it back to yen, you pay off the loan and you have a 5% return. This is
only perfect when there is no volatility in exchange rate. The yen appreciated (door hawkish beleid) so hedge
funds have to pay back more yen. If the yen appreciates more than 5%, you’re making a loss.
2. Political risk
Political risk: arises from the fact that a sovereign country can change the “rules of the game” and the affected
parties may not have effective recourse.
ð Multinational corporations and international investors are exposed to political risks when they operate
in certain foreign countries or hold foreign assets.
ð Political risks range from unexpected changes in tax rules to outright expropriation of assets held by
foreigners.
ð Especially relevant in those countries without a tradition of the rule of law, where the rights of
shareholders and investors may not be protected.
3. Market imperfections
Market imperfections: are frictions and impediments hampering free movements of people, goods, services,
and capital across national boundaries and preventing markets from functioning perfectly:
ð Legal restrictions
ð Transaction and transportation costs
ð Information asymmetry (ex buyers are more informed than the sellers)
ð Discriminatory taxation
World markets: are highly imperfect.
ð Motivates MNCs to locate production overseas.
ð Restricts the extent to which investors can diversify their portfolios.
4
Why study international finance?
The world economy is highly globalized and increasingly integrated in:
ð The markets for goods and services → consumption & production of goods & services.
ð The financial markets → allows investors to diversify investment portfolios internationally.
Today, all the major economic functions are globalized:
ð Consumption.
ð Production.
ð Investment.
What’s special about international finance?
4 major dimensions: set international finance apart from domestic finance.
1) Foreign exchange risk
2) Political risks (ex. decisions made by Trump, war between Ukrain & Russia)
3) Market imperfections
4) Expanded opportunity set (expand your company)
These are largely because sovereign nations have the right to issue currencies, formulate their own economic
policies, impose taxes, and regulate movements of people, goods, and capital across their borders.
1. Foreign exchange risk
Foreign exchange risk: stems from uncertain future exchange rates.
ð For example: profits made in a foreign currency may disappear once converted into the domestic
currency due to unanticipated exchange rate movements.
ð Exchange rates among major currencies (ex U.S. dollar, Japanese yen, British pound, and euro) fluctuate
continuously in an unpredictable manner.
ð Exchange rate uncertainty influences all major economic functions, including consumption, production,
and investment.
Example: if you are a US international company and you make 1.000.000 YEN in Japan, but the YEN deprecia-
ted so you lost some money from converting your profit from YEN to Dollar.
3 major currencies in the world: USD (takes up 60% of all currencies around the world), Euro (20% of all
international reserves), Chinese YUAN (CNY and CNH for being traded in China and HongKong).
ð All these currencies fluctuate, depending on the arrangements.
1
,Hawkish: restrictive = quantitative tightening.
ð Quantitative tightening: central banks ensure that a smaller amount of money circulates in the economy.
ð They try to raise interest rates, reduce the money supply, and sell government bonds (by the central
bank).
ð This helps them fight inflation and strengthen their currency (a higher interest rate makes the yen more
attractive).
ó Dovish policy: expansionary = quantitative easing.
ð Lowering interest rates, increasing the money supply, and the central bank buys government bonds, so
the government receives cash.
ð Investing in Japan is beneficial for European and American countries due to this hawkish policy.
Example: suppose $1 = ¥100 today, and you invest $1,000 to buy 50 shares of Toyota at ¥2,000 per share. One
year later, the share price has increased by ten percent, and your investment is worth ¥110,000. If the yen has
depreciated to $1 = ¥120 by that time, how much is your investment worth in dollar terms?
ð Initial investment in dollars: $1,000.
ð Initial investment in yen: $1,000 × (¥100/$) = ¥100,000.
ð Maturity value in yen: ¥110,000 (after 10% increase).
ð Maturity value in dollars: ¥110,000 / (¥120/$) = $916.67.
Answer:
ð Disturbing: the way that currencies are stated on the internet.
ð 10% appreciation yen, 20% depreciation dollar, so you loose 10%? No.
ð If you have a 10% depreciation you need more than 10% to bring it back up.
ð What would be the return of the investment? Return = (The new price – the old price)/ the old price
ð Pt-1 = 1000 USD
ð Pt = 916,67 USD
ð Return USD = (916,67 – 1000)/1000 =-0,0833
ð Pt-1 = 100 000 YEN
ð Pt = 110 000 YEN
ð Return YEN = (110000 – 100000)/100000 =0,1
Loss: because of depreciation of the yen.
ð It’s a floating market, because it changes all the time.
ð If the central bank is dovish so they lower interest rates, it pushes down the value of the currency
because you earn less money when holding the yen.
ð You receive less interest because of the lower interest rates.
2
, You have the value of the YEN in USD, always look
at what the Y axe is.
If it’s going up, then you need more YEN by one
dollar.
Appreciation of the USD, depreciation of the
USD.
If you want more purchasing power, go to Japan,
it will be cheaper there.
This is the percentage change, so this means that
the YEN depreciated by 30% from the level it was
the year before.
The depreciation was fast and strong over a short
time period.
Extra information on decpreciation & devaluation:
ð A depreciation is not a devaluation.
ð Devaluation or depreciation means a chance of higher inflation because imports are more expensive.
o Export is cheaper.
Depreciation - Happens because of market forces.
- Is about supply & demand.
- For example: a decline in foreign investments in Japan.
- Happens in a floating exchange rate environment.
Devaluation - Is a discretionary choice made by the monetary authorities.
- Imports will be more expensive & exports will be cheaps (both cases = case of deva-
luation & depreciation).
- Typically in a fixed exchange rate environment.
- The value of the currency is linked to another currency.
3
, What is a “carry trade”: it is an investment strategy in which an investor borrows money in a currency with a
low interest rate and invests it in a currency or asset with a higher interest rate.
ð The goal is to profit from the difference between the low borrowing rate and the higher return on the
investment.
ð For example: if interest rates in Japan are low (e.g., 0.5%) and rates in Australia are higher (e.g., 5%), an
investor could borrow Japanese yen at the low rate, exchange them for Australian dollars, and invest in
Australian bonds to earn the higher interest rate.
ð The profit comes from the interest rate differential, as long as exchange rates remain stable.
Borrowing cheap money in Japan and convert that money in USD to then invest in the US. Then when you have
the interest on your money, you convert it back to yen, you pay off the loan and you have a 5% return. This is
only perfect when there is no volatility in exchange rate. The yen appreciated (door hawkish beleid) so hedge
funds have to pay back more yen. If the yen appreciates more than 5%, you’re making a loss.
2. Political risk
Political risk: arises from the fact that a sovereign country can change the “rules of the game” and the affected
parties may not have effective recourse.
ð Multinational corporations and international investors are exposed to political risks when they operate
in certain foreign countries or hold foreign assets.
ð Political risks range from unexpected changes in tax rules to outright expropriation of assets held by
foreigners.
ð Especially relevant in those countries without a tradition of the rule of law, where the rights of
shareholders and investors may not be protected.
3. Market imperfections
Market imperfections: are frictions and impediments hampering free movements of people, goods, services,
and capital across national boundaries and preventing markets from functioning perfectly:
ð Legal restrictions
ð Transaction and transportation costs
ð Information asymmetry (ex buyers are more informed than the sellers)
ð Discriminatory taxation
World markets: are highly imperfect.
ð Motivates MNCs to locate production overseas.
ð Restricts the extent to which investors can diversify their portfolios.
4
