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International Finance Test 1 Study Guide

Chapter 1

Why Study International Finance?

• The world economy is increasingly globalized and integrated in:

  • Consumption

  • Production

  • Investment

• International finance helps firms navigate global financial markets.

What’s Special About International Finance?

1. Foreign Exchange Risk – Uncertain exchange rates can impact profits when converting currencies.

2. Political Risk – Governments can change economic policies, affecting foreign investments.

3. Market Imperfections – Barriers to free trade such as legal restrictions, taxes, and information asymmetry.

4. Expanded Opportunity Set – Access to global markets allows firms to lower costs and increase efficiency.

Foreign Exchange Risk Example

• If exchange rates fluctuate, foreign investment returns can change when converted back to the home currency.

Political Risk

• Governments can alter rules (e.g., tax laws, expropriation).

• More severe in countries without strong legal protections for investors.

Market Imperfections

• Friction in markets prevents free movement of goods and capital.

• Example: Nestlé had different stock classes for foreigners and Swiss residents, creating price distortions.

Expanded Opportunity Set

• Firms can:

  • Choose optimal locations for production.

  • Raise capital in global markets.

• Investors can:

  • Diversify internationally to lower risk and improve returns.

Goals of International Financial Management

• Shareholder Wealth Maximization – Primary goal in countries like the U.S., U.K., Australia, and Canada.

• Stakeholder Perspective – More common in Europe and Japan, where firms also focus on employees, suppliers, and banks.

Corporate Governance

• Agency Problem – Managers may prioritize personal gains over shareholder interests.

• Corporate Governance helps align management with shareholders through regulations and legal frameworks.

Globalization of the World Economy: Major Trends

1. Emergence of Globalized Financial Markets – Driven by deregulation and financial innovations.

2. Emergence of the Euro – The European Central Bank (ECB) oversees the euro, creating a unified European capital market.

3. Europe’s Sovereign Debt Crisis (2010) – Greece's financial crisis exposed weaknesses in the eurozone (monetary union without fiscal unity).

4. Trade Liberalization & Economic Integration – Promoted by comparative advantage (countries specialize in what they do best).

   • GATT → WTO: Enforces trade rules globally.

   • EU, NAFTA (now USMCA): Regional trade agreements remove barriers.

5. Privatization – Selling state-owned businesses to the private sector to improve efficiency.

6. Global Financial Crisis (2008-2009) – U.S. subprime mortgage crisis triggered a worldwide recession.

7. Brexit (2016-2020) – U.K. exit from the EU due to economic and national identity concerns.

8. COVID-19 Pandemic – Disrupted economies, led to inflation, and widened income inequality.

9. Climate Change – A long-term economic and financial threat, with initiatives like the Paris Agreement (2015) to curb global warming.

Multinational Corporations (MNCs)

• Firms incorporated in one country but operating globally.

• Benefits of being an MNC:

  • Economies of scale – Spreading costs over a larger market.

  • Global purchasing power – Better deals from suppliers.

  • Access to cheap labor and specialized R&D.

Key Takeaways

• Foreign Exchange Risk and Political Risk are major concerns in international finance.

• Market Imperfections create barriers but also opportunities for MNCs.

• Trade liberalization and financial integration drive globalization.

• MNCs benefit from an expanded global market but must manage financial and political risks.

• Understanding globalization is key to financial management in today's world.

Chapter 2

International Monetary System Overview

• A framework of rules and mechanisms governing exchange rates, international payments, and capital flow.

• Evolved through various monetary systems over time.

Evolution of the International Monetary System

1. Bimetallism (Before 1875)

   • Gold & silver used as money.

   • Gresham’s Law: The abundant metal was used, while the scarce metal disappeared from circulation.

2. Classical Gold Standard (1875-1914)

   • Gold-backed currencies with fixed exchange rates.

   • Advantages: Stable exchange rates, controlled money supply, automatic trade balance adjustments.

   • Disadvantages: Limited money supply, lack of enforcement.

3. Interwar Period (1915-1944)

   • Gold standard collapsed due to World War I.

   • Economic instability, Great Depression, and lack of a global monetary system.

4. Bretton Woods System (1945-1972)

   • U.S. dollar pegged to gold ($35 per ounce), other currencies pegged to the U.S. dollar.

   • Created IMF & World Bank.

   • Collapsed due to the Triffin Paradox: The U.S. had to run deficits to supply global reserves, reducing confidence in the system.

5. Flexible Exchange Rate Regime (1973-Present)

   • Jamaica Agreement (1976) legalized floating exchange rates.

   • Central banks intervene to manage excessive volatility.

   • Gold officially abandoned as a reserve asset.

Current Exchange Rate Arrangements

1. Fixed Exchange Rate Systems

   • Currency Board: Currency fully backed by foreign reserves (e.g., Hong Kong).

   • Conventional Peg: Currency tied to another currency (e.g., Saudi Arabia).

   • Crawling Peg: Gradual adjustments (e.g., Nicaragua).

2. Floating Exchange Rate Systems

   • Managed Float: Some government intervention (e.g., China).

   • Free Float: Market-driven exchange rates (e.g., U.S., U.K., Japan).

Cryptocurrencies & Central Bank Digital Currencies (CBDCs)

• Cryptocurrency: Decentralized, blockchain-based digital currency (e.g., Bitcoin, Ethereum).

• Fiat Currency: Issued by governments, not backed by physical assets.

• CBDCs: Government-backed digital currencies, still under development.

European Monetary System & the Euro

• Established in 1979 to stabilize exchange rates.

• Euro introduced in 1999, replacing national currencies in the Eurozone.

• European Central Bank (ECB) manages monetary policy.

• Advantages: Eliminates exchange rate risk, increases economic integration.

• Disadvantage: Loss of national monetary policy flexibility.

Currency Crises

1. Mexican Peso Crisis (1994-1995)

   • Mexico devalued the peso, triggering capital flight.

   • Lessons: Need for stronger domestic savings & crisis management mechanisms.

2. Asian Currency Crisis (1997-1998)

   • Thai baht collapsed, leading to capital outflows across Asia.

   • Caused severe recessions in affected countries.

   • Key Issue: "Incompatible Trinity"—fixed exchange rate, free capital flows, and independent monetary policy cannot coexist.

3. Argentine Peso Crisis (2002)

   • Peso-dollar peg collapsed due to lack of fiscal discipline & economic downturn.

   • Led to political and financial turmoil.

Rise of the Chinese Renminbi (RMB)

• China is a global economic powerhouse, but its currency is not fully convertible.

• Included in IMF’s Special Drawing Rights (SDR) since 2016.

• To become a global currency, China needs:

  1. Full RMB convertibility.

  2. Deep & liquid financial markets.

  3. Stronger legal protections.

Fixed vs. Flexible Exchange Rates

Fixed Exchange Rate Advantages:

• Stability in trade & investment.

• Lower inflation.

Flexible Exchange Rate Advantages:

• Automatic external adjustments.

• Monetary policy independence.

Ideal International Monetary System Should:

• Provide liquidity for global trade.

• Have a mechanism for balance adjustments.

• Include crisis prevention safeguards.

Key Takeaways

• The international monetary system has evolved from gold-based systems to floating exchange rates.

• Currency crises highlight the risks of poor financial management and external shocks.

• The Eurozone integrates economies but limits national monetary policies.

• The Chinese RMB is rising, but full convertibility is needed.

• Fixed & flexible exchange rates each have pros & cons, with no perfect system.

Chapter 3

1. Understanding the Balance of Payments (BoP)

• Balance of Payments: A record of a country’s international transactions over a period, using double-entry bookkeeping.

• Why It’s Important:

  • Indicates demand and supply for a country’s currency.

  • Assesses a country’s economic performance in global trade.

  • Helps predict economic stability.

Accounting Principles

• Credit (+): When a country receives money from foreigners (e.g., exports, foreign investments).

• Debit (-): When a country pays money to foreigners (e.g., imports, foreign asset purchases).

2. BoP Accounts

1. Current Account – Tracks trade, income, and transfers.

2. Capital Account – Measures capital transfers and sales of non-produced, non-financial assets.

3. Financial Account – Tracks investments in stocks, bonds, and direct investments.

4. Official Reserves Account – Central bank transactions to manage exchange rates.

3. Current Account Components

1. Goods Trade – Exports & imports of physical products.

2. Services Trade – Transactions in consulting, finance, royalties, tourism, shipping.

3. Primary Income – Earnings from foreign investments (interest, dividends).

4. Secondary Income – Foreign aid, remittances, and transfers.

Impact of Currency Changes

• Depreciation: Boosts exports, reduces imports (cheaper currency).

• J-Curve Effect: Trade balance worsens before improving after depreciation.

4. Capital Account

• Covers one-time, large transactions, such as:

  • Land, mineral rights, airspace, trademarks, and patents.

  • Capital transfers, like debt forgiveness.

5. Financial Account

• Tracks cross-border investments, divided into:

  1. Foreign Direct Investment (FDI) – Investors gain control over a foreign business.

  2. Portfolio Investment – Buying stocks and bonds without control.

  3. Other Investments – Bank deposits, trade credits, currency transactions.

6. Statistical Discrepancy

• BoP records are not perfect due to timing & data differences.

• Helps ensure BoP identity balances.

Overall Balance

• Sum of Current, Capital, Financial Accounts, and Statistical Discrepancy.

• If there’s a gap, it's financed via the Official Reserves Account.

7. Official Reserves Account

• Managed by the central bank to balance payments.

• Reserve assets include:

  • Gold

  • Foreign exchange holdings

  • IMF Special Drawing Rights (SDRs)

8. Balance of Payments Identity (BoP Identity)

BCA+BKA+BFA+BRA=0BCA + BKA + BFA + BRA = 0BCA+BKA+BFA+BRA=0

Where:

• BCA = Current Account Balance

• BKA = Capital Account Balance

• BFA = Financial Account Balance

• BRA = Reserves Account Balance

Impact of Exchange Rate Regimes

• Fixed Exchange Rate: BoP imbalances managed with official reserves.

• Floating Exchange Rate: No reserve adjustments; exchange rates adjust automatically.

9. BoP Trends in Major Countries

United States & United Kingdom

• Current account deficits since 1982.

• Financial account surpluses due to foreign capital inflows.

Germany

• Current account surplus due to high exports.

• Temporary deficits (1991-2001) from German reunification.

Japan

• Continuous current account surplus since 1982.

• Financial account deficit (major creditor nation).

China

• Current & financial account surplus (until recently).

• Massive reserve accumulation.

Global Imbalances

• U.S. & U.K.: Consume more than they produce.

• China, Japan, & Germany: Produce more than they consume.

Key Takeaways

• BoP tracks global financial flows and exchange rate impacts.

• Current account focuses on trade & income, while financial account tracks investments.

• Official reserves stabilize exchange rates in fixed systems.

BoP trends show global imbalances between debtor (U.S., U.K.) and creditor (China, Japan, Germany) nations.