International Business Finance

 International Business Finance

This volume seeks to provide a basic working knowledge of international busi-

ness finance. Corporate aspects of international finance are analyzed, especially

hedging techniques. It also aims to help readers understand how managers of inter-

national corporations do or should behave and examines the mechanics of the

foreign exchange market, reviewing spot, forwards, futures, and options—the

main tools used to hedge exchange rate risk. The book also constructs the building

blocks of international finance: (1) interest rate parity, (2) purchasing power

parity, and (3) the international Fisher equation. It then turns to international

management issues, international financial scams, and the Sarbanes-Oxley Act of

2002, which attempts to address them. Finally, the book lays out the optimal

portfolio model in an international setting based upon an investor’s degree of risk

aversion and the reward–risk ratio.

For those new to international finance, I strongly recommend a reference

book for terminology: John Downes and Jordan Elliot Goodman, Dictionary of

Finance and Investment Terms, seventh edition, Barron’s Financial Guides, Barron’s

Educational Series, 2006.

I have kept explanations to a minimum. More important is the understanding

of the concepts rather than their derivations or lengthy elaboration. Over the

years, I have developed these materials for my MBA and Executive MBA students

in international finance at the University of Miami, and have been honored by

several prizes for excellence in teaching at Miami. My students in international

finance at Duke University kindly provided suggestions on the final version of the

manuscript.

Originally from Longford, Ireland, I started work as a newspaper boy in

Phoenix, Arizona, where I learned the concept of credit risk when collecting

accounts receivable. Each delivery boy was his own independent operator, buying

newspapers from the Phoenix Gazette and selling them to subscribers—something

not understood by the subscriber on my route who had an especially high rate of

default. At UC Berkeley as an undergraduate, I worked in restaurants and the

library. At the University of Chicago, I benefited from a scholarship to the Ph.D.

program in economics where I had the great fortune of having Nobel Laureate

Robert Mundell as my Ph.D. thesis advisor. Upon graduation, I held teaching

positions at Harvard University, at the University of Florida, in South Carolina,

and at Columbia University. I now teach and advise on international business at

the University of Miami and at Hunan University, Changsha, China. I also do

economic impact reports for projects such as Rivertown, a condominium complex

in Miami, the Miami Performing Arts Center, the School of Medicine of the

University of Miami, and The Miami Partnership, a civic center revitalization

project. The latter applies net present value calculations—the time value of

money, using the cost of borrowing of Miami-Dade County. As a consultant to

UBS Warburg, I had the opportunity to work with Michael Gavin, Managing

Director, on the underwriting of sovereign debt in emerging markets in 2002 and

2003. It has also been a privilege to teach courses in Cameroon and the Ivory

Coast, Africa, in Paris at the Université de Paris-Dauphine, at the Université

d’Auvergne, France, in Mexico at ITAM, Mexico City, in Costa Rica, Peru, and

at IDEM, Uruguay, in Latin America. As a consultant, I participated in World

Bank finance and trade missions to Mongolia, Uzbekistan, Ecuador, Peru,

Cameroon, Kenya, Malawi, and Sénégal.

In recent years, I have been teaching finance and trade at Hunan University,

China, as well as doing joint research with colleagues there. It is exciting to take

part in China’s movement toward free markets and the development of financial

markets for risk management, hedging, and trading. Futures markets in petro-

leum were only opened in March 2005, and there are still neither deliverable

forwards in the yuan nor in foreign exchange, such as the US dollar. In 2006,

foreign banks and companies may have full ownership of local operations. Capital

transfers still require approval of SAFE, the State Administered Foreign Exchange

System, which approved the failed $18.5 billion CNOOC Ltd offer for UNOCAL.

The Chinese government is encouraging direct foreign investment and acquisi-

tions, making available the foreign exchange necessary for these investments.

My colleague in the finance department at the University of Miami, Tie Su,

made especially helpful comments and suggestions that significantly improved the

exposition. Discussions with Adam Swartz of the University of Mississippi clari-

fied my thinking on a number of topics. My greatest debt of gratitude is to Robert

Z. Aliber of the Graduate School of Business, University of Chicago, and to Ed

Tower, Duke University, who made significant, detailed suggestions on the

content and focus of the volume. Robert Langham, the Economics and Finance

Editor of Taylor and Francis Books plc, London, shepherded the project through

its various stages, suggesting additional coverage. Emma Rasiel, Duke University,

helped out on bid–ask spread-corrected interest rate parity, and on margin

requirements. Alexandre Moltchanov provided able research assistance.

The plan of the book is as follows:

Chapter 1 introduces the topic of international finance by highlighting its main

characteristics, in particular currency risk and conversion.

Chapter 2 begins with the history of international finance and monies, stressing

the importance of money as a medium of exchange, a store of value, and a unit of

account. Bills of exchange are identified as the source of the first financial securi-

ties in foreign currency and the origin of the stock exchanges.

Chapter 3 concerns the exchange rate. The foreign exchange market is analyzed,

including spot, future, forward, options, and swap markets in foreign exchange.

The basic building block for forecasting future exchange rates—interest rate

parity—is illustrated as a no-profit arbitrage condition. The bid–ask spread—the

difference between the ask and the bid price of foreign exchange dealers—

represents the currency dealers’ profits, in addition to any commission paid, and

as a transaction cost in currency conversion for the firm. Unanticipated foreign

exchange risk involves the risk that a subsequent spot rate will deviate from its

current forward level. Forwards and foreign exchange swaps are analyzed and laid

out as a particularly useful way of hedging long-term and operational commitments

in foreign exchange.

Chapter 4 deals with the hedging of foreign exchange risk by the firm. To hedge

or not is the first issue addressed, then hedging techniques. If a firm or an individ-

ual has a “long” position in say euros, foreign exchange risk is said to be hedged or

guarded against by acquiring an equal and opposite “short” position in euros. A sim-

ple hedge of a million euros of accounts receivable in 90 days could involve the

sale of one million euros forward for delivery in 90 days. The firm would no longer

be subject to foreign exchange risk: neither unanticipated gains if the euro rises

relative to the forward price in dollars or pounds, nor unanticipated losses if the

euro declines relative to the forward rate. Chapter 4 also covers contractual

hedges: futures, forwards, money market hedges, and options, as well as opera-

tional, accounting, and transactional hedging by the international business.

Chapter 5 deals with international financial management issues that confront

the multinational firm: transfer pricing, working capital management, inter-

national taxation, offshore banking, and international mergers and acquisitions.

In addition, the currency conversion of free-cash flows in an international busi-

ness plan is covered in detail.

Chapter 6 covers financial scams and swindles, including pyramid schemes,

insider trading, accounting malfeasance, and other scams that have surged world-

wide in recent years. Partly, the problem seems to be old-fashioned greed, but

another culprit seems to be the linking of bonus and options compensation with

reported earnings, not necessarily actual earnings.

Problem sets are also provided at the end of Chapters 3, 4, and 5 to give the

reader confidence in problem-solving with numerical and conceptual analysis, and

answers to these sets and an index close the book.

When I was a graduate student at the University of Chicago, the Black-Scholes

model for the valuation of options was not yet published, Robert Merton had not

done his seminal work in continuous finance, and John Hull had not yet completed

his classic reference on forwards and futures. I did benefit from Robert Mundell’s

courses in international money and open-economy macroeconomics while at

Chicago. At Harvard, I published in international finance with Stephen Ross of

MIT, who went on to establish his mark in agency and options theory. Finally, I

am pleased to acknowledge financial support from Project 985, Hunan University,

for this project. I hope you enjoy this little volume. My students do and I had

fun writing it.

Michael Connolly

School of Business Administration,

University of Miami, Florida

College of Finance, Hunan University,

Changsha, People’s Republic of China

Editor, The Journal of Economic Policy Reform