Table Of ContentInternational Finance
International Finance
Theory into Practice
Piet Sercu
Copyright © 2009 by Princeton University Press
Published by Princeton University Press,
41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press,
6 Oxford Street, Woodstock, Oxfordshire OX20 1TW
All Rights Reserved
ISBN: 978-0-691-13667-7 (alk. paper)
Library of Congress Control Number: 2008941943
British Library Cataloging-in-Publication Data is available
This book has been composed in LucidaBright using TEX
Typeset and copyedited by T&T Productions Ltd, London
Printed on acid-free paper
press.princeton.edu
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
Contents
Preface
Acknowledgments
I Introduction and Motivation for International Finance
1 Why Does the Existence of Borders Matter for Finance?
1.1 Key Issues in International Business Finance
1.2 What Is on the International CFO’s Desk?
1.3 Overview of this Book
2 International Finance: Institutional Background
2.1 Money and Banking: A Brief Review
2.2 The International Payment Mechanism
2.3 International (“Euro”) Money and Bond Markets
2.4 What Is the Balance of Payments?
2.5 Exchange-Rate Regimes
Test Your Understanding
II Currency Markets
About This Part
3 Spot Markets for Foreign Currency
3.1 Exchange Rates
3.2 Major Markets for Foreign Exchange
3.3 The Law of One Price for Spot Exchange Quotes
3.4 Translating FC Figures: Nominal Rates, PPP Rates, and Deviations from PPP
3.5 CFO’s Summary
3.6 Technical Notes
Test Your Understanding
4 Understanding Forward Exchange Rates for Currency
4.1 Introduction to Forward Contracts
4.2 The Relation between Exchange and Money Markets
4.3 The Law of One Price and Covered Interest Parity
4.4 The Market Value of an Outstanding Forward Contract
4.5 CFO’s Summary
4.6 Appendix: Interest Rates, Returns, and Bond Yields
4.7 Appendix: The Forward Forward and the Forward Rate Agreement
Test Your Understanding
5 Using Forwards for International Financial Management
5.1 Practical Aspects of Forwards in Real-World Markets
5.2 Using Forward Contracts (1): Arbitrage
5.3 Using Forward Contracts (2): Hedging Contractual Exposure
5.4 Using Forward Contracts (3): Speculation
5.5 Using Forward Contracts (4): Minimizing the Impact of Market Imperfections
5.6 Using the Forward Rate in Commercial, Financial, and Accounting Decisions
5.7 CFO’s Summary
Test Your Understanding
6 The Market for Currency Futures
6.1 Handling Default Risk in Forward Markets: Old and New Tricks
6.2 How Futures Contracts Differ from Forward Markets
6.3 Effect of Marking to Market on Futures Prices
6.4 Hedging with Futures Contracts
6.5 The CFO’s Conclusion: Pros and Cons of Futures Contracts Relative to Forward
Contracts
6.6 Appendix: Eurocurrency Futures Contracts
6.7 Technical Notes
Test Your Understanding
7 Markets for Currency Swaps
7.1 How the Modern Swap Came About
7.2 The Fixed-for-Fixed Currency Swaps
7.3 Interest-Rate Swaps
7.4 Cross-Currency Swaps
7.5 CFO’s Summary
7.6 Technical Notes
Test Your Understanding
8 Currency Options (1): Concepts and Uses
8.1 An Introduction to Currency Options
8.2 Institutional Aspects of Options Markets
8.3 An Aside: Futures-Style Options on Futures
8.4 Using Options (1): Arbitrage
8.5 Using Options (2): Hedging
8.6 Using Options (3): Speculation
8.7 CFO’s Summary
Test Your Understanding
9 Currency Options (2): Hedging and Valuation
9.1 The Logic of Binomial Option Pricing: One-Period Problems
9.2 Notation and Assumptions for the Multiperiod Binomial Model
9.3 Stepwise Multiperiod Binomial Option Pricing
9.4 Toward Black–Merton–Scholes (European Options)
9.5 CFO’s Summary
9.6 Technical Notes
Test Your Understanding
III Exchange Risk, Exposure, and Risk Management
About This Part
10 Do We Know What Makes Forex Markets Tick?
10.1 The Behavior of Spot Exchange Rates
10.2 The PPP Theory and the Behavior of the Real Exchange Rate
10.3 Exchange Rates and Economic Policy Fundamentals
10.4 Conclusion
10.5 Technical Notes
11 Do Forex Markets Themselves See What Is Coming?
11.1 The Forward Rate as a Black-Box Predictor
11.2 Forecasts by Specialists
11.3 CFO’s Summary
Test Your Understanding
12 (When) Should a Firm Hedge Its Exchange Risk?
12.1 The Effect of Corporate Hedging May Not Just Be “Additive”
12.2 FAQs about Hedging
12.3 CFO’s Summary
Test Your Understanding
13 Measuring Exposure to Exchange Rates
13.1 The Concepts of Risk and Exposure: A Brief Survey
13.2 Contractual-Exposure Hedging and Its Limits
13.3 Measuring and Hedging of Operating Exposure
13.4 Accounting Exposure
Test Your Understanding
14 Value-at-Risk: Quantifying Overall Net Market Risks
14.1 Risk Budgeting: A Factor-Based, Linear Approach
14.2 The Linear/Normal VaR Model: Potential Flaws and Corrections
14.3 Historical Backtesting, Bootstrapping, Monte Carlo, and Stress Testing
14.4 CFO’s Summary
14.5 Epilogue: The Credit Crunch Blues
Test Your Understanding
15 Managing Credit Risk in International Trade
15.1 Payment Modes without Bank Participation
15.2 Documentary Payment Modes with Bank Participation
15.3 Other Standard Ways of Coping with Default Risk
15.4 CFO’s Summary
Test Your Understanding
IV Long-Term International Funding and Direct Investment
About This Part
16 International Fixed-Income Markets
16.1 “Euro” Deposits and Loans
16.2 International Bond and Commercial-Paper Markets
16.3 How to Weigh Your Borrowing Alternatives
16.4 CFO’s Summary
Test Your Understanding
17 Segmentation and Integration in the World’s Stock Exchanges
17.1 Background Information on International Stock Markets
17.2 Why Don’t Exchanges Simply Merge?
17.3 Can Unification Be Achieved by a Winner Taking All?
17.4 CFO’s Summary
Test Your Understanding
18 Why—or When—Should We Cross List Our Shares?
18.1 Why Might Companies Want to List Shares Abroad?
18.2 Shareholders’ Likely Reaction to Diversification Opportunities
18.3 Sifting through the Empirics on Cross-Listing Effects
18.4 CFO’s Summary
Test Your Understanding
19 Setting the Cost of International Capital
19.1 The Link between Capital-Market Segmentation and the Sequencing of Discounting
and Translation
19.2 The Single-Country CAPM
19.3 The International CAPM
19.4 The CFO’s Summary re Capital Budgeting
19.5 Technical Notes
Test Your Understanding
20 International Taxation of Foreign Investments
20.1 Forms of Foreign Activity
20.2 Multiple Taxation versus Tax Neutrality
20.3 International Taxation of a Branch (1): The Credit System
20.4 International Taxation of a Branch (2): The Exclusion System
20.5 Remittances from a Subsidiary: An Overview
20.6 International Taxation of a Subsidiary (1): The Credit System
20.7 International Taxation of a Subsidiary (2): The Exclusion System
20.8 CFO’s Summary
Test Your Understanding
21 Putting It All Together: International Capital Budgeting
21.1 Domestic Capital Budgeting: A Quick Review
21.2 InNPV Issue #1: How to Deal with the Implications of Nonequity Financing
21.3 InNPV Issue #2: How to Deal with Exchange Rates
21.4 InNPV Issue #3: How to Deal with Political Risks
21.5 Issue #4: Make Sure to Include All Incremental Cash Flows
21.6 Other Things to Do in Spreadsheets While You’re There
21.7 CFO’s Summary
21.8 Technical Notes
Test Your Understanding
22 Negotiating a Joint-Venture Contract: The NPV Perspective
22.1 The Three-Step Approach to Joint-Venture Capital Budgeting
22.2 A Framework for Profit Sharing
22.3 Case I: A Simple Pro-Rata Joint Branch with Neutral Taxes and Integrated Capital
Markets
22.4 Case II: Valuing a Pro-Rata Joint Branch when Taxes Differ
22.5 Case III: An Unbundled Joint Venture with a License Contract or a Management
Contract
22.6 CFO’s Summary and Extensions
Test Your Understanding
Further Reading
References
Index
Preface
About This Book
Updating International Financial Markets and the Firm, the 1995 forerunner to this book by
me and Raman Uppal, was something that we had wanted to do for a long time. By 2004,
Raman and I reluctantly agreed that a text full of Italian lira or German marks, and where
traders still had a full two minutes to respond to market makers’ quotes, might sooner or later
get outdated. Starting the revision itself turned out to be much more difficult than agreeing on
the principle, though. In the end Raman, being so much busier and more rational than I am,
preferred to bow out. How right he was. Still, now that the effort has become a sunk cost,
forever bygone, I find that episodes where I sincerely curse the book (and myself and Princeton
University Press) are becoming fewer and farther between. Actually, there are now several
passages I almost like.
The book targets finance students, or at least students that want a genuine finance text, not an
international-management or -strategy text with a finance slant nor an international monetary
economics text with some corporate applications. There is a continued bias in favor of
financial markets and economic logic; the aim is to provide students with a coherent picture of
international markets and selected topics in multinational corporate finance. Sure, during
everyday practice later on, this framework will then get amended and corrected and qualified;
but the feeling of fundamental coherence will remain, I hope.
This book is still more analytical than the modal text in the field. But there is less math than
in the Sercu–Uppal book, and it is brought in differently. Many of the appendixes are gone or
have been much shortened. While in International Financial Markets we had every theorem
or proof followed by an example, now the example comes first whenever possible. If so, the
proof is often even omitted, or turned into a do-it-yourself assignment. In fact, a third
innovation is that, at least in the chapters or sections that are sufficiently analytical rather than
just factual, the reader is invited to prove or verify claims and solve analogous problems. The
required level of math is surely not prohibitive; anybody who has finished a good finance
course should be able to master these do-it-yourself assignments.
Every part, except the first, now has its own introductory case, which is intended to
stimulate the reader’s appetite and which can be a source of assignments. The cases usually
cover issues from most chapters in the part.
A fifth change is that the part on exchange-rate pricing is much reduced. The chapters on
exchange-rate theories, predictability, and forward bias are now shrunk to one (admittedly
long) chapter. And, lastly, three wholly new chapters have been added: two on international
stock markets—especially cross listing with the associated corporate-governance issues—and
one on Value-at-Risk.
Typically, a preface like this one continues with a discussion and motivation of the book’s
content. But my feeling is that most readers—and surely students—skip prefaces anyway. Since
the motivation of the structure is quite relevant, that material is now merged into the general
introduction, chapter 1.
