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991.qxd 7/15/2006 11:41 AM Page 1 Batch number: 1 CHECKLIST (must be completed before press) Fourth (Please cross through any items that are not applicable) edition Front board: Spine: Back board: ❑ Title ❑ Title ❑ ISBN ❑ Subtitle ❑ Subtitle ❑ Barcode ❑ Author/edited by ❑ Author/edited by ❑ Series title ❑ Extra logo if required Maurice D. Levi INTERNATIONAL FINANCE ❑ Extra logo if required International Finance General: ❑ Book size ❑ Type fit on spine CIRCULATED Date: SEEN BY DESK EDITOR: REVISE NEEDED Initial: Date: APPROVED FOR PRESS BY DESK EDITOR Initial: Date: Maurice D. Levi ISBN 978-0-415-30899-1 ,!7IA4B www.routledge.com ï an informa business PC4 Royal Demy B-format Spine back edge International Finance Fourth edition In today’s global economy, the international business community requires a thorough knowledge and understanding of the complexities of international finance. In this fourth edition, Maurice D. Levi successfully integrates both the micro and macro aspects of international finance. The author explores managerial issues and focuses on problems that arise from financial trading relations between nations, while covering key topics such as: “ organization of foreign exchange markets, “ determination of exchange rates, “ the fundamental principles of international finance, “ foreign exchange risk and exposure, “ fixed and flexible exchange rates. This impressive new edition builds and improves upon the popular style and structure of the original. With new data, improved pedagogy, and coverage of all of the main developments in international finance over the last few years, this book will prove essential reading for economics and business students. Maurice D. Levi has 30 years of teaching experience in the area of international finance. International Finance Fourth edition Maurice D. Levi First published 2005 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN Simultaneously published in the USA and Canada by Routledge 270 Madison Avenue, New York, NY 10016 Routledge is an imprint of the Taylor & Francis Group # 2005 Maurice D. Levi Typeset in Perpetua and Bell Gothic by Newgen Imaging Systems (P) Ltd, Chennai, India Printed and bound in Great Britain by Bell & Bain Ltd, Glasgow All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0–415–30899–2 (hbk) ISBN 0–415–30900–X (pbk) To Kate ‘‘As for foreign exchange, it is almost as romantic as young love, and quite as resistant to formulae.’’ H.L. Mencken (As you shall see, it is not entirely resistant to formulae!)  About the author Since receiving his PhD from the University of Chicago, Maurice D. Levi has taught and written research papers in a wide variety of areas of finance and economics. This broad range of research and teaching inter- ests form the foundation for this book in international finance, a subject that he believes to be best treated as an application of financial and economic principles, rather than as a separate and isolated subject area. Professor Levi has published research papers on financial market anomalies, the effectiveness of monetary and fiscal policy, the relationship between inflation and interest rates, the effect of taxes on international capital flows, and the link between inflationary expectations and unemployment, as well as in the numerous areas of international finance that are reflected in this book. He has also written in the areas of econometric methods, macroeconomics, labor economics, environmental economics, money and banking, and regional economics. His papers have appeared in just about every leading research journal in finance and economics including: American Economic Review; Econometrica; Journal of Political Economy; Journal of Finance; Journal of Monetary Economics; Journal of Money, Credit and Banking; Journal of International Money and Finance; Journal of International Economics; Management Science; Ecological Economics, and Journal of Econometrics. He is also the author of Economics and the Modern World (Heath, Lexington MA, 1994), Economics Deciphered: A Layman’s Survival Guide (Basic Books, New York, 1981), and Thinking Economically (Basic Books, New York, 1985) and the coauthor, with M. Kupferman, of Slowth (Wiley, New York, 1980). Since joining the Sauder School of Business of the University of British Columbia, Professor Levi has held visiting positions at the Hebrew University of Jerusalem, the University of California, Berkeley, MIT, the National Bureau of Economic Research, the University of Exeter, University of New South Wales, and the London Business School. He has received numerous academic prizes and awards including Killam and Nomura Fellowships and the Bronfman Award.  Contents List of illustrations xiii Preface xviii 1 THE WORLD OF INTERNATIONAL FINANCE 1 Unique dimensions of international finance 1 The benefits of studying international finance 1 The growing importance of international finance 2 Topics covered in this book 13 Summary 17 Review questions 17 Assignment problems 18 Bibliography 18 Parallel material for case courses 19 Appendix A 19 Appendix B 22 PART I THE MARKETS FOR FOREIGN EXCHANGE 27 2 AN INTRODUCTION TO EXCHANGE RATES 29 The foreign bank note market 29 The spot foreign exchange market 32 Organization of the interbank spot market 32 Direct versus indirect exchange and cross exchange rates 43 Summary 50 Review questions 51 Assignment problems 51 Bibliography 52 3 FORWARD EXCHANGE 53 What is forward foreign exchange? 53 Forward exchange premiums and discounts 54 Forward rates versus expected future spot rates 56 Payoff profiles on forward exchange 56 Outright forward exchange and swaps 58 vii & CONTENTS The flexibility of forward exchange 60 Forward quotations 61 Summary 65 Review questions 66 Assignment problems 66 Bibliography 67 4 CURRENCY FUTURES AND OPTIONS MARKETS 68 Currency futures 68 Currency options 75 Forwards, futures, and options compared: a summary 85 Summary 86 Review questions 87 Assignment problems 88 Bibliography 89 Appendix A 89 PART II THE DETERMINATION OF EXCHANGE RATES 95 5 THE BALANCE OF PAYMENTS 97 Influences on currency supply and demand 97 Principles of balance-of-payments accounting 98 Balance-of-payments entries and the factors that influence them 99 Implications of the balance-of-payments accounting identity 108 The net international investment position 111 Objectives of economic policy 113 Summary 114 Review questions 116 Assignment problems 116 Bibliography 117 6 SUPPLY-AND-DEMAND VIEW OF EXCHANGE RATES 119 Imports, exports, and exchange rates 120 The factors affecting exchange rates 122 The stability of exchange rates 130 Short-run versus long-run trade elasticities and the J curve 133 Summary 135 Review questions 136 Assignment problems 136 Bibliography 137 Appendix A 137 PART III THE FUNDAMENTAL INTERNATIONAL PARITY CONDITIONS 141 7 THE PURCHASING-POWER-PARITY PRINCIPLE 143 The law of one price 143 Absolute (or static) form of the PPP condition 144 The relative (or dynamic) form of PPP 145 & viii  CONTENTS Efficient markets (or speculative) form of PPP 147 The empirical evidence on PPP 148 Reasons for departures from PPP 151 Statistical problems of evaluating PPP 152 The practical importance of PPP 154 Summary 155 Review questions 156 Assignment problems 156 Bibliography 157 8 INTEREST PARITY 159 The investment and borrowing criteria 160 The covered interest-parity condition 166 Combining PPP and interest parity 169 Why covered interest differences persist 171 Summary 184 Review questions 185 Assignment problems 186 Bibliography 187 PART IV MANAGING FOREIGN EXCHANGE RISK AND EXPOSURE 189 9 FOREIGN EXCHANGE EXPOSURE AND RISK 191 The importance of understanding risk and exposure and measuring them 191 The nature of exchange-rate risk and exposure 192 Examples of foreign exchange exposure 193 Exposure as a regression slope 198 Definition of foreign exchange risk 204 Exposure, risk, and the parity relationships 205 Summary 211 Review questions 213 Assignment problems 213 Bibliography 214 10 ACCOUNTING EXPOSURE VERSUS REAL EXPOSURE 216 Accounting principles 216 Real changes in exchange rates 220 Summary 226 Review questions 227 Assignment problems 227 Bibliography 228 11 OPERATING EXPOSURE 230 Operations affected by exchange rates 230 The exporter 231 The importer 240 Summary of effects of exchange rates on exporters and importers 244 Effect of currency of invoicing and forward hedging 244 Measuring exposure: an alternative approach 249 Summary 251 ix & CONTENTS Review questions 252 Assignment problems 253 Bibliography 254 12 HEDGING RISK AND EXPOSURE 256 Whether to hedge: managerial hedging versus shareholder hedging 256 Hedging of receivables and payables 259 The cost of forward hedging 260 The benefit of forward hedging 264 Financial engineering: payoff profiles of different hedging techniques 272 Having a company hedging policy 276 Summary 276 Review questions 277 Assignment problems 278 Bibliography 279 13 EXCHANGE-RATE FORECASTING AND SPECULATION 280 Speculation 280 Market efficiency 283 Exchange-rate forecasting 288 Summary 300 Review questions 302 Assignment problems 302 Bibliography 303 PART V INTERNATIONAL INVESTMENT AND FINANCING 305 14 CASH MANAGEMENT 307 The objectives of cash management 307 Investment and borrowing choices with transaction costs 308 International dimensions of cash management 310 Summary 319 Review questions 320 Assignment problems 320 Bibliography 321 15 PORTFOLIO INVESTMENT 322 The benefits of international portfolio investment 322 International capital asset pricing 331 Bonds and international portfolio diversification 339 Settlements of international portfolio investments 341 Summary 341 Review questions 343 Assignment problems 343 Bibliography 344 16 CAPITAL BUDGETING FOR FOREIGN INVESTMENTS 346 Selecting projects 346 Difficulties in evaluating foreign projects 348 &x  CONTENTS Cash flows: home versus foreign perspectives 349 Discount rates: corporate versus shareholder perspectives 351 The adjusted-present-value technique 351 Selecting the appropriate discount rates 354 An example 356 Actual practice of capital budgeting 360 Summary 361 Review questions 362 Assignment problems 362 Bibliography 363 Appendix A 364 The different forms of taxes 364 Organizational structures for reducing taxes 367 Appendix B 369 17 THE GROWTH AND CONCERNS ABOUT MULTINATIONALS 373 The growth of MNCs 373 Special issues facing MNCs: transfer pricing 381 Special issues facing MNCs: country risk 384 Problems and benefits from the growth of MNCs 390 Transnational alliances 393 Summary 393 Review questions 395 Assignment problems 395 Bibliography 396 18 INTERNATIONAL DIMENSIONS OF LONG-TERM FINANCING 397 Equity financing 397 Bond financing 402 Bank financing, direct loans, and the like 410 Government and development-bank lending 413 Other factors affecting the financing of subsidiaries 413 Financial structure 414 Summary 417 Review questions 418 Assignment problems 418 Bibliography 419 PART VI INSTITUTIONAL STRUCTURE OF INTERNATIONAL TRADE AND FINANCE 421 19 MULTINATIONAL BANKING 423 The Eurodollar and offshore currency markets 423 Multinational banking 431 Summary 441 Review questions 442 Assignment problems 442 Bibliography 443 20 INSTRUMENTS AND INSTITUTIONS OF INTERNATIONAL TRADE 445 Extra dimensions of international trade 445 International trade involving letters of credit: an overview of a typical transaction 445 xi & CONTENTS Alternative payment and guaranteeing procedures 450 The financing of international trade 452 Countertrade 456 The institutions regulating international trade 459 Summary 463 Review questions 464 Assignment problems 464 Bibliography 465 PART VII THE INTERNATIONAL MACROECONOMIC ENVIRONMENT: THEORIES AND PRACTICES 467 21 ASSET-BASED THEORIES OF EXCHANGE RATES 469 Stock versus flow theories of exchange rates 469 The monetary theory of exchange rates 469 The asset approach to exchange rates 474 The portfolio-balance approach to exchange rates 475 Theories of exchange-rate volatility 479 Summary 483 Review questions 484 Assignment problems 484 Bibliography 485 22 ALTERNATIVE SYSTEMS OF EXCHANGE RATES 487 The classical gold-standard system 488 The Bretton Woods and dollar standards 491 The European monetary system (EMS) 496 Hybrid systems of exchange rates 499 Target zones 502 Summary 504 Review questions 506 Assignment problems 506 Bibliography 507 Appendix A 508 Appendix B 511 23 THE INTERNATIONAL FINANCIAL SYSTEM: PAST, PRESENT, AND FUTURE 514 The past 514 The present 529 The future 529 Degree of exchange-rate flexibility: fixed versus flexible exchange rates 536 Summary 543 Review questions 544 Assignment problems 545 Bibliography 546 Glossary 547 Name index 573 Subject index 578 & xii  Illustrations FIGURES 1.1 Percentage of GDP arising from exports 3 1.2 International investment position of the United States 10 1B.1 The gain from the better allocation of capital 23 1B.2 Utility from different consumption patterns 24 2.1 Daily turnover in the US foreign exchange market, 1986–2001 33 2.2 Organization of the foreign exchange market 35 2.3 Interbank spot and selected forward exchange rates 41 2.4 Direct versus indirect exchange: zero transaction costs 44 2.5 Direct versus indirect exchange: nonzero transaction costs 47 3.1 Payoff profile on forward contract to buy ¤1 million 58 3.2 Payoff profile on forward contract to sell ¤1 million 59 4.1 Prices of principal CME currency futures: September 18, 2003 69 4.2 Payoff profile for purchase of euro futures contract 74 4.3 Premiums on principal CME options on currency futures: September 18, 2003 76 4.4 Payoff profiles of buyer and writer of euro call option for ¤125,000 84 4.5 Payoff profiles of buyer and writer of euro put option for ¤125,000 85 4A.1 Equivalence of buying foreign currency European call and selling put, versus buying the foreign currency forward 90 4A.2 Equivalence of selling foreign currency European call and buying put, versus selling the foreign currency forward 90 6.1 Deriving the supply of pounds 121 6.2 Deriving the demand for pounds 122 6.3 The exchange rate from imports and exports 123 6.4 Deriving the demand for imports 124 6.5 Deriving the export supply curve 125 6.6 Inflation in relation to supply and demand 126 6.7 Inflation and exchange rates 127 6.8 Currency supply and import elasticity 131 6.9 Stability of foriegn exchange markets 132 6.10 The J curve 134 7.1 US–Mexican inflation and the peso–dollar exchange rate 154 8.1 Dollar versus hedged pound investments 161 8.2 Dollar versus hedged pound borrowing 164 8.3 Covered interest arbitrage: dollar borrowing and pound investing 165 xiii & ILLUSTRATIONS 8.4 The covered interest parity diagram 167 8.5 The interdependence of exchange rates, interest rates, and inflation rates 171 8.6 One way and round-trip interest arbitrage 174 8.7 Interest parity in the presence of transaction costs, political risk, or liquidity premiums 175 8.8 A more roundabout one-way arbitrage 178 9.1 Exposure as the slope of a regression line 199 11.1 Exporter and devaluation in a competitive market 232 11.2 Exporter and devaluation in a competitive market: effect of cost increases 235 11.3 Devaluation and the demand curve 236 11.4 Exporter and devaluation in an imperfectly competitive market 237 11.5 Exporter and devaluation in an imperfectly competitive market: foreign-currency units 239 11.6 The importer and a devaluation 241 11.7 Importer and devaluation in foreign-currency units 243 11.8 Importer of inputs and devaluation 244 11.9 Exporter with payables exposure: dollar accounting 246 11.10 The J curve 246 12.1 Payoff profiles, payables exposure, and resulting exposure with forward and futures contracts 273 12.2 Payoff profiles from option hedges 275 14.1 Example of Navistar International’s foreign exchange netting system 316 14.2 Digital Equipment’s weekly cash cycle 318 15.1 Correlations between US and other countries’ stock markets, US dollars, 1980–90 323 15.2 Correlations between Japanese and other countries’ stock markets, Japanese yen, 1980–90 324 15.3 Correlations between British and other countries’ stock markets, British pounds, 1980–90 324 15.4 The size of the gain from international diversification 327 15.5 Local-market versus exchange-rate components of volatility of US dollar values of non-US stocks, 1970s and 1980s 328 15.6 The advantages of international diversification with and without exchange risk 330 15.7 The relationship between expected return and total risk 333 15.8 Efficiency frontier of global stocks, US dollar, 1980–90 334 15.9 Contribution of bonds to the globally efficient frontier, US dollars, 1980–90 341 17.1 Euromoney’s country-risk rating scheme 386 18.1 Parallel loans and credit swaps 412 19.1 Deposit and asset shares of foreign banks in the United States, 1990–2001 432 19.2 Share of loans by foreign banks in the United States, 1990–2001 432 20.1 Application and agreement for documentary letter of credit 447 20.2 The draft and banker’s acceptance 448 20.3 The steps in international trade 449 20.4 The steps involved in forfaiting 454 20.5 The different forms of countertrade 458 21.1 The portfolio-balance theory: effect of open-market operations 476 21.2 Real income growth and the portfolio-balance theory 478 21.3 Exchange-rate overshooting 480 22.1 The workings of the gold-exchange and dollar standards 493 22.2 The price-level adjustment mechanism of the gold-exchange and dollar standards 495 22.3 Crawling peg 500 22.4 Target zones for exchange rates 503 23.1 Post-war changes in economic importance 530 & xiv  ILLUSTRATIONS 23.2 US and Japanese trade balances, 1965–2002 533 23.3 US bilateral trade balance with China and Japan, 1985–2003 534 23.4 Stabilizing and destabilizing currency speculation 540 TABLES 1.1 Aggregate international trade versus GDP 3 1.2 Selected foreign exchange gains, 2001 6 1.3 Selected foreign exchange losses, 2001 7 1.4 The volatility of exchange rates 12 1A.1 The situation with no international trade 20 1A.2 Input/output under free trade 21 2.1 Exchange rates on foreign bank notes (Traveler’s dollar – October 22, 2002) 30 2.2 Geographical distribution of average daily foreign exchange turnover, April 2001 32 3.1 Foreign exchange net turnover by market segment: daily averages, April 2001 53 3.2 Per annum percentage premium (þ) or discount () on forward foreign exchange vis-à-vis the US dollar 55 3.3 Unanticipated changes in the spot exchange rate and gains or losses on forward purchase of ¤1 million at $1.15/¤ 57 3.4 Unanticipated changes in the spot exchange rate and gains or losses on forward sale of ¤1 million at $1.15/¤ 58 3.5 Foreign exchange derivative turnover by currency pair: daily turnover in April 2001 63 3.6 Bids and asks on pounds 64 4.1 Settlements on a pound futures contract 71 4.2 Realized spot rates and gains/losses on futures to buy euros 73 4.3 Impact of variables affecting currency call and put option premiums 79 4.4 Payoffs on purchase of euro call option 83 4.5 Payoffs on purchase of euro put option 85 4.6 Forwards, futures, and options compared 86 4A.1 European option put-call forward parity 92 5.1 Summary format of the US balance of payments, 3rd quarter, 2002 100 5.2 International investment position of the United States year-end 2001 112 7.1 Average absolute deviations from PPP 149 8.1 Exchange rates and interest rates on different currency-denominated 3-month bank deposits 163 8.2 Points off the interest parity line 168 9.1 Exposure on a contractual asset: euro bank deposit 193 9.2 Exposure on a contractual liability: euro bank loan 194 9.3 Exposure on a noncontractual asset: Euro-zone exporter 195 9.4 Exposure on a noncontractual asset: Euro-zone exporter 195 9.5 Exposure on a noncontractual asset: Euro-zone importer 196 9.6 Exposure on a noncontractual asset: euro bond 197 9.7 Exposure on a noncontractual asset: dollar bond 197 9.8 Exposure on a noncontractual asset: foreign real estate 198 10.1 Earnings on domestic versus foreign financial assets 222 10.2 Earnings on foreign fixed assets 225 12.1 Dollar payments on £1-million accounts payable using different hedging techniques 265 12.2 Payoffs from different hedging techniques 272 13.1 Test of unbiasedness of forward rates as predictors of future spot rates, monthly data 1978–87 287 xv & ILLUSTRATIONS 13.2 Correlation coefficients between the yen–dollar spot rate and various possible spot-rate predictors, 1974–87 289 13.3 Correlation coefficients between the Deutschemark–dollar spot rate and various possible spot-rate predictors, 1974–87 289 13.4 The performance of econometric-oriented services 293 13.5 Speculative return on capital from following the advice of econometric services 294 13.6 Speculative return on capital from following the advice of technical services 295 13.7 Connection between past changes in exchange rates and median forecasts of future rates: different forecast horizons 299 13.8 Forecasting methods of Euromoney respondents 299 14.1 Factors affecting working-capital management 315 15.1 Monthly US dollar returns and risks for national stock markets, 1994–2002 325 15.2 Correlations between US dollar monthly returns in automobile manufacturing, 1986–91 326 15.3 Correlations between US dollar monthly returns in the consumer electronics industry, 1986–91 326 15.4 Composition of US dollar weekly returns on individual foreign stock markets, 1980–85 329 16.1 Value of a £1-million concessionary loan 353 16.2 Adjusted-present-value elements for Turkish jeans factory 359 16A.1 Corporate income tax rates, 2003 365 17.1 The 50 largest nonfinancial MNCs, ranked by total assets, 2000 374 17.2 Euromoney’s country-risk ranking, 2003 388 18.1 Costs of foreign-currency bonds 405 18.2 Sources of funds for subsidiaries 411 18.3 Mean and standard deviation of debt to asset ratios, sorted by type of legal system 415 19.1 Change in balance sheets from $100 of primary deposits 430 19.2 Activities open to different institutions in different centers 438 EXHIBITS 1.1 Currency matters: corporate experiences 8 1.2 Getting a grip on globalization 9 2.1 Institutional basics of the foreign exchange market 36 2.2 An exchange on the exchange: a conversation between market-makers in the foreign exchange market 39 3.1 Structure of the forward market 61 3.2 Differences between outright forwards and swaps 62 4.1 The scope for writing options 82 5.1 Extraterrestrial trade or the ether? Data difficulties in the balance of payments 107 9.1 Hedging horizons 207 9.2 Flying high: risk and exposure at American airlines 209 10.1 Translating accountants’ and economists’ languages 218 10.2 From historical to current rates: the rationale for a change in approach 219 11.1 A practical solution to estimating operating exposure 249 12.1 To hedge or not to hedge: Merck’s motives 258 12.2 Different corporate choices over hedging 261 13.1 The success of professional forecasters 297 13.2 Good luck or good judgement? 298 14.1 Decentralizing currency management at general electric 314 15.1 Home bias and corporate governance 336 15.2 Evolution of capital market integration 340 16.1 Investment strategies: a dynamic matter 347 & xvi  ILLUSTRATIONS 16.2 Competitive pressure to pursue FDI 348 17.1 Counting on a good name 377 17.2 Multinationals: creatures of market imperfections 380 17.3 Do US multinationals export jobs? 392 18.1 Overstating differences: US-Japanese borrowing costs more similar than it seems 399 18.2 Going abroad: the appeal of Euroequities 400 18.3 Special drawing rights (SDRs) 409 19.1 Foreign bank operations in the United States 433 19.2 Derivatives: differentiating the hyperbole 440 20.1 Just-in-time inventory systems: too late for The Merchant of Venice 453 20.2 US free-trade zones 461 22.1 The Wonderful Wizard of Oz: a monetary allegory 492 22.2 Alphabet soup: ERM, EMS, ECU, and all that 498 23.1 Seeing the forest through the trees: the Bretton Woods vision 517 23.2 Bretton Woods faces the axe 521 23.3 The cost of change: conversion to the euro 528 23.4 The bank for international settlements 531 23.5 International trade and the environment 535 xvii &  Preface This book is intended for use in MBA and senior-level undergraduate business courses in international finance and international business. It is comprehensive, covering both the markets and management of multinational business. It is designed to be used in its entirety in courses that cover all areas of international finance, or to be used selectively in courses dealing only with international financial markets or only with international financial management. To the extent possible, the two major subdivisions of international finance are self contained, being delivered in separate segments. The book is specifically designed for students who have taken introductory economics and finance, and who wish to build upon the basic financial and economic principles they have acquired. By assuming these prerequisites, this book is able to go further than competing textbooks in international finance. It is able to introduce the student to the new and exciting discoveries and developments in the dynamic and rapidly expanding field of international finance. These discoveries and developments, many of which have occurred during the last few years, are extensions of the principles of finance and economics. Of course, it is necessary to recognize that business students, whether concentrating in finance or in international business, have a practical interest in the subjects they take. Consequently, a good textbook in international finance must cover real managerial topics such as how to evaluate foreign investment opportunities, where to borrow and invest, how exchange rates affect cash flows, what can be done to avoid foreign exchange exposure and risk, and the general financial management problems of doing business in the global environment. However, even these highly practical topics can be properly dealt with only by applying basic financial and economic principles that many other international finance textbooks appear reluctant to employ. As a result, despite adequate levels of preparation, generally including thorough introductions to economics and finance, the student often receives a rather descriptive treatment of these topics that fails to build on the foundations of previous courses. For this reason, many MBA students and undergraduate business majors with solid backgrounds in, for example, the consequences of arbitrage or the principles of capital budgeting feel they move sideways rather than forward into international finance. The topics in this text are covered from the perspective of a person who wishes to learn about the financial management of an internationally oriented business. However, it is important that managers also understand international financial developments on a macroeconomic level. Such an understanding enables managers to anticipate economic changes and adjust to what they expect to occur. Because of this double level of interest in the forces behind events and the consequences of these events for the firm, this book includes several chapters on the international finance of the economy. However, these chapters are divided into two parts, with the essential material on the international financial environment limited to only two chapters in the early part of the book. This is to provide the book with a financial management focus, & xviii  PREFACE unlike the previous three editions that have given more priority to the wider picture of the global economy. The aspects of the international financial environment that are less essential to day-to-day international financial decisions are in a separate section at the end of the book. Nevertheless, even at this more aggregate level, a managerial perspective is taken, with the material linked to factors relevant to the handling of volatility that has its roots in global events. This book represents a major revision and updating of the third edition of International Finance that go beyond moving less essential material on the international financial environment to later in the book. New topics have been included and topics previously covered have been considerably rearranged and reintegrated. In addition, additional examples have been provided. The guiding principle throughout this substantial revision has been to bring the book closer to the syllabus that is emerging in one-semester international finance courses in MBA and senior level undergraduate business programs. Most particularly, an attempt has been made to go beyond theory and into the vital and increasingly important real world of international finance. As with previous editions, a substantial revision has been necessary because the international financial developments that are occurring are nothing short of spectacular. For example, new markets and instruments are emerging at a frantic pace, in part as a response to exchange rates that at times have been so volatile they have grabbed the headlines, not of the business section of the newspaper, but of the front page. The day-to-day lives of people have been affected by events such as the introduction of the euro, a common currency now shared by numerous countries in Europe. The euro represents an unprecedented experiment in international financial cooperation with huge implications for the traveler and the person in the street as well as corporate financial management. Great fortunes have been made and lost in foreign exchange. News reports have also been full of exchange rate crises in Asia, South and Central America, and Russia, and economic summits of world leaders dealing with these periodic crises. At the same time, there has been an explosion of research in international finance and international financial management. The revisions in this fourth edition of International Finance reflect the important recent developments and current research that have sharpened the insights from studying this dynamic subject. This book has evolved over a number of years while teaching or doing research at the University of British Columbia and also at the Hebrew University, Jerusalem; the University of California, Berkeley; the Massachusetts Institute of Technology; the London Business School; the University of New South Wales; and the University of Exeter. I am indebted to all these institutions, especially the Sauder School of Business at the University of British Columbia, which has been my home base for over three decades. An author’s debts are a pleasure to acknowledge, and in the course of four editions of this book I have incurred many I would find difficult to repay. A huge debt is owed to Cynthia Ree who has spent endless days and weeks providing a usable electronic copy from which I could work, and to my colleague Ali Lazrak who has provided valuable comments. The help offered by reviewers has been immensely important in improving the final product. Only the anonymity of the individual reviews prevents me from apportioning the vast credit due to them. My wife, Kate, son Adam, and daughter Naomi have provided professional and indispensable help in preparing the manuscript. My son Jonathan also helped by asking questions that sharpened my understanding of difficult matters. Too numerous to mention individually but of great importance were the students in my MBA and undergraduate courses in international finance at the University of British Columbia, whose reactions have been a crucial ingredient in the revision of this text. It is to my wife, Kate, and my daughter Naomi that I owe my greatest thanks. In addition to playing a vital role in preparing and checking the manuscript they have provided the moral support and encouragement that have made a fourth venture far less stressful than I had imagined. Maurice D. Levi Vancouver, BC xix &  Chapter 1 The world of international finance The globe is not a level playing field. Anonymous UNIQUE DIMENSIONS OF Other special, uniquely international financial INTERNATIONAL FINANCE problems arise from the fact that there are political divisions as well as currency divisions between While tradition dictates that we continue to refer to countries. In particular, the world is divided into the subject matter in this book as international nation-states that generally, but not always, corre- finance, the modifier ‘‘international’’ is becoming spond to the currency divisions: some nations share increasingly redundant: today, with fewer and currencies, such as the euro that is the common fewer barriers to international trade and financial currency for numerous European nations, and the flows, and with communications technology Russian ruble that is still used by several former directly linking every major financial center, all Soviet states. Political barriers provide additional finance is becoming ‘‘international.’’ Indeed, not opportunities and risks when engaging in overseas only are domestic financial markets increasingly borrowing and investment. International finance has internationally integrated, but the problems faced as its focus the problems managers face from these by companies and individuals in different lands are currency and country divisions and their associated remarkably similar. opportunities and risks. Even though most if not all finance must be viewed at the international level, there are special problems that arise from financial and trading THE BENEFITS OF STUDYING relations between nations. These are the problems INTERNATIONAL FINANCE addressed in this book. Many of these problems are due to the use of different currencies used in dif- Knowledge of international finance can help a ferent countries and the consequent need to financial manager decide how international events exchange them. The rates of exchange between will affect a firm and what steps can be taken to currencies – the amount of a currency received for exploit positive developments and insulate the firm another – have been set by a variety of arrange- from harmful ones. Among the events that affect the ments, with the rates of exchange as well as the firm and that must be managed are changes in arrangements themselves subject to change. exchange rates as well as interest rates, inflation Movements in exchange rates between currencies rates, and asset values. These different changes can have profound effects on sales, costs, profits, are themselves related. For example, declining asset and liability values, and individual well-being. exchange rates tend to be associated with relatively 1& THE WORLD OF INTERNATIONAL FINANCE high interest rates and inflation. Furthermore, some corporations (MNCs) that have received so much asset prices are positively affected by a declining attention in the media. It is just as valid for a currency, such as stock prices of export-oriented company with a domestic focus that happens to companies that are more profitable after devalua- export a little of its output or to buy inputs from tion. Other asset prices are negatively affected, such abroad. Indeed, even companies that operate only as stock prices of companies with foreign-currency domestically but compete with firms producing denominated debt that lose when the company’s abroad and selling in their local market are affected home currency declines: the company’s debt is by international developments. For example, US increased in terms of domestic currency. These clothing or appliance manufacturers with no over- connections between exchange rates, asset and lia- seas sales will find US sales and profit margins bility values, and so on mean that foreign exchange affected by exchange rates which influence the is not simply a risk that is added to other business dollar prices of imported clothing and appli- risks. Instead, the amount of risk depends crucially ances. Similarly, bond investors holding their own on the way exchange rates and other financial prices government’s bonds, denominated in their own are connected. For example, effects on investors currency, and spending all their money at home, are when exchange rates change depend on whether affected by changes in exchange rates if exchange asset values measured in foreign currency move in rates prompt changes in interest rates. Specifically, the same direction as the exchange rate, thereby if governments increase interest rates to defend reinforcing each other, or in opposite directions, their currencies when their currencies fall in value thereby offsetting each other. Only by studying on the foreign exchange markets, holders of international finance can a manager understand domestic bonds will find their assets falling in value matters such as these. International finance is not along with their currencies: bond prices fall when just finance with an extra cause of uncertainty. It is a interest rates increase. It is difficult to think of any legitimate subject of its own, with its own risks and firm or individual that is not affected in some way or ways of managing them. other by the international financial environment. There are other reasons to study international Jobs, bond and stock prices, food prices, govern- finance beyond learning about how exchange rates ment revenues, and other important financial vari- affect asset prices, profits, and other types of effects ables are all tied to exchange rates and other described earlier. Because of the integration of developments in the increasingly global financial financial markets, events in distant lands, whether environment. they involve changes in the prices of oil and gold, election results, the outbreak of war, or the THE GROWING IMPORTANCE OF establishment of peace, have effects that instantly INTERNATIONAL FINANCE reverberate around the Earth. The consequences of events in the stock markets and interest rates of one While we shall emphasize the managerial issues of country immediately show up around the globe, international finance in this book, it is important to which has become an increasingly integrated and emphasize that the international flows of goods and interdependent financial environment. The links capital that are the source of supply of and demand between money and capital markets have become so for currencies, and hence essential to the subject close as to make it futile to concentrate on any of international finance, are fundamental to our individual part. well-being. A strong currency, for example, ceteris In this book we are concerned with the prob- paribus, improves a country’s standard of living: lems faced by any firm whose performance is affec- the currency buys more in world markets. Not ted by the international environment. Our analysis only does a strong currency allow citizens to buy is relevant to more than the giant multinational more imports, they can also buy more domestically &2  THE WORLD OF INTERNATIONAL FINANCE produced products that are internationally traded commerce. For example, since 1950, world trade because a country’s citizens have to compete with has grown by about 6 percent per annum, roughly foreigners for their own country’s tradable pro- twice that of world output over the same period. ducts. The gain in standard of living from a rising During the nineteenth century, international trade currency is also evident when living standards are grew at such a tremendous rate that it increased by compared between nations. International rankings a factor of 25 times in the century leading up to of living standards require conversions of local- the First World War. Even in the period since currency incomes into a common measure, usually 1980, a mere moment in the long history of the US dollar. A rising currency moves a country up international trade, the value of trade between the ladder by making local incomes worth more nations has tripled (see Table 1.1). Growth in dollars. the importance of trade in the form of the fraction Citizens also gain from the efficient global allo- of Gross Domestic Product (GDP) consisting of cation of capital: when capital is allocated to its best exports is shown for several countries in Figure 1.1. uses on a global scale, overall returns are higher and these extra returns can be shared among the global & Table 1.1 Aggregate international trade investors. Let us therefore pause to consider the versus GDP evidence of the international movement of goods Year World exports, Exports/GDP% and capital. We shall also take a look at the sources billion US$ of gains from the flows of goods and capital. We 1999 4945.9 16.0 shall see that international finance is a subject of 1995 4531.7 15.7 immense and growing importance. 1990 3070.0 14.2 1985 1610.8 13.7 The growth of international trade 1980 1541.3 14.7 Source: National Account Statistics: Analysis of Main International trade has a pervasive importance for our Aggregates, United Nations, New York, 2003. standard of living and our daily lives. In the depart- ment store we find cameras and electrical equipment 50% from Japan and clothing from China and India. On the 1970 40% 1990 street we find automobiles from Germany, Japan, 1999 Korea, Sweden, and France using gasoline from 30% Nigeria, Saudi Arabia, Great Britain, Mexico, and 20% Kuwait. At home we drink tea from India, coffee from Brazil, whiskey from Scotland, beer from 10% Germany, and wine from just about every country on Earth. We have become so used to enjoying these 0% Canada South United United India products from distant lands that it is easy to forget Korea Kingdom States they are the result of complex international trading and financial linkages discussed in this book. & Figure 1.1 Percentage of GDP arising from exports Note Record on the growth of trade Today, foreign markets represent a more important proportion of aggregate demand for the products of most countries than in Peoples and nations have been trading from time the past. For example, the fraction of US GDP that is exported has almost doubled since 1970, while the fraction of South immemorial. During the period since records have Korea’s GDP that is exported has almost tripled. been kept the amount of this trade between nations Source: National Account Statistics: Analysis of Main has typically grown at a faster rate than has domestic Aggregates, United Nations, New York, 2003. 3& THE WORLD OF INTERNATIONAL FINANCE Indeed, if anything, the published export figures currency implications, making the trend of para- understate the growth of world trade. This is mount importance to international finance. For suggested by the fact that when the world’s example, the euro has become the common cur- combined reported exports are compared to rency of many of the members of the EU, motivated reported imports, global imports exceed exports. by the desire to reduce the foreign exchange risks In the absence of extraterrestrial trade, this sug- and currency conversion costs of doing business gests a reporting error: when properly calculated, within this important customs union.1 The pre- global imports must equal global exports. The vious currencies of this area have completely dis- mechanisms for reporting imports are generally appeared: no more German marks, Italian lira, and better than those for reporting exports – govern- so on. The role of the US dollar within NAFTA has ments keep track of imports for collection of become a source of serious debate: should there be a duties and for safety and health reasons – and North American common currency to reduce risks therefore it is likely that exports are understated and costs in this important and possibly expanding rather than that imports are overstated. It is worth region? pausing to consider why international trade and the The second factor contributing to growing trade, international financial activity associated with that namely the shrinkage of ‘‘economic space’’ caused trade have grown so rapidly in recent decades. by a lower cost of communication and transporta- tion, has had a profound effect. For example, in real terms, long-distance telephone costs have been Reasons for the growing importance of reduced by more than 90 percent since the 1920s. international trade Connection times have been reduced even more There are two principal reasons why international dramatically: long-distance calls used to be con- trade has grown so rapidly: nected manually by operators who would route calls through available lines.2 The cost of inter- 1 A liberalization of trade and investment via national business travel by air has dropped so reductions in tariffs, quotas, currency controls, substantially that it can cost little more for a US and other impediments to the international executive to meet with an Asian or European client flow of goods and capital. than another US executive in another US city. Air 2 An unprecedented shrinkage of ‘‘economic freight and ocean tanker costs for transporting space’’ via rapid improvements in commun- goods have also fallen rapidly. This has resulted in a ication and transportation technologies, and globalization of markets and consequent rapid consequent reductions in costs. 1 A customs union is different from a free-trade area. Much of the trade liberalization has come from the A customs union maintains common levels of tariffs and development of free-trade areas such as that of the other trade restrictions against nonmembers while having European Union (EU) now consisting of more free trade between the union members. A free-trade area allows countries to maintain different tariffs and other than two dozen countries from Sweden to Malta and restrictions against nonmembers. This limits the ability Portugal to Greece, and that of the United States, of goods and services to move freely between members of a Canada, and Mexico which signed the North free-trade area: countries must check when products move American Free Trade Agreement (NAFTA) in across borders to see if they are produced by member 1993. Similarly, rapid growth of trade has occurred countries or by nonmember countries. among the members of the Association of South 2 See Ronald Abler, ‘‘Effect of Space-Adjusting Technologies on the Human Geography of the Future,’’ in Human East Asian Nations (ASEAN). Indeed, more and Geography in a Shrinking World, Ronald Abler, Donald more of global trade is occurring within trading Janelle, Allen Philbrick and John Sommer (eds), Duxbury blocks. This regionalization of trade has important Press, North Scituate, MA, 1975, pp. 35–56. &4  THE WORLD OF INTERNATIONAL FINANCE growth in international financial activity for settling Italy, grow faster than other regions, or why parts transactions on the multinational scale. of industries expand while others contract. Dynamic Given the growing importance of international factors, rather than static production efficiencies trade, it is worth briefly considering the rewards and ‘‘factor endowments,’’ play a vital role in and risks that accompany it. This will allow us to international trading success by offering count- briefly introduce some of the matters discussed at ries competitive advantages. In particular, length later in this book. countries typically are successful internationally in products for which there are dynamic, discerning buyers at home. For example, the French success The rewards of international trade in wine and cheese, German success in beer and The principal reward of international trade is that it finely engineered automobiles, British success in has brought about increased prosperity by allowing cookies, Italian success in fashion and US success in nations to specialize in producing those goods entertainment, are all in part due to the presence of and services at which they are relatively efficient. consumers in the respective countries whose The relative efficiency of a country in producing a sophisticated tastes have forced firms to produce particular product can be described in terms of the first-class products to maintain their markets. Once amounts of other, alternative products that could be successful at home, these firms have been able to produced by the same inputs. In other words, succeed abroad. we can think of relative efficiencies in terms of A further factor affecting success in international the opportunity cost of one product in terms of trade is the presence of suppliers and firms in sup- another. When considered this way, relative effi- portive industries in the vicinity of exporting firms. ciencies are described as comparative advan- For example, in southern California the US enter- tages. All nations can and do simultaneously gain tainment industry can call on lighting and camera from exploiting their comparative advantages, as engineers, actors and screen designers, and even such well as from the larger scale production and bro- ‘‘extras’’ as exotic animal trainers and explosives ader choice of products that is made possible by experts. Other so-called ‘‘clusters’’ of supportive international trade.3 activities are found in the northern German chemical In the last few years it has become increasingly industry, Mid-Western US automobile industry, recognized that there is more to successful inter- northern Italian manufacturing industry and the national trade than comparative advantages based on Tokyo–Osaka-based consumer-electronics sector. productive efficiencies.4 These particular advan- tages cannot explain distinct patterns of success, The risks of international trade such as Singapore and Hong Kong’s rapid growth with limited resources, versus Argentina’s slow The rewards of trade do not come without economic advance despite abundant natural advan- accompanying risks. The most obvious additional tages. Also, comparative advantages do not explain risk of international versus domestic trade arises why some regions within countries, such as northern from uncertainty about exchange rates. Unexpected changes in exchange rates have important impacts 3 For those who have not learned or have forgotten the on sales, prices and profits of exporters and principle of comparative advantage, a summary is given in importers. For example, if a Scottish whiskey Appendix A at the end of this chapter. The gains from exporter faces an unexpected increase in the value exploitation of comparative advantage are no different of the pound from $1.5/£ to $1.6/£, a bottle of from the gains from specialization within a country. 4 This recognition is in large part due to the influential book whiskey sold for £10 will increase in price in the by Michael E. Porter, The Competitive Advantage of Nations, United States from $15 to $16. This will reduce Harvard University Press, Cambridge, MA, 1989. sales, and since the Scottish exporter receives 5& THE WORLD OF INTERNATIONAL FINANCE & Table 1.2 Selected foreign exchange gains, 2001: millions of US dollars Company Country Gain Net Inc. (Loss) Fx.Gain (%) Industry Citicorp USA 2,383 9,642 25 Banking/Finance Barclays UK 1,470 3,585 41 Banking/Finance Deutsche Bank Germany 1,233 149 828 Banking/Finance UBS Swiss. 1,232 2,996 41 Banking/Finance HSBC UK/HK 600 5,406 11 Banking/Finance Ford Motors USA 283 (5,453) n/d Auto. Manuf. IBM USA 198 7,723 3 Computing Chevron/Texaco USA 191 3,288 6 Energy Deutsche Telekom Germany 178 (3,074) n/d Telecommunications Telefonos De Mex. Mexico 127 2,566 5 Telecommunications Rio Tinto UK 58 1,079 5 Mining China Petroleum China 45 1,936 2 Mining Inco Canada 39 305 13 Mining Xerox USA 29 (71) n/d Bus. Equip. BHP Billiton Australia 29 1,348 2 Mining China Eastern China 15 65 23 Airlines Apple Comp. USA 15 (25) n/d Computing Can. Pacific Canada 9 258 4 Railway Nortel Canada 9 (27,446) n/d Telecommunications Source: COMPUSTAT, 2003. Information contained in this document is subject to change without notice. Standard and Poor’s assumes no responsibility or liability for any errors or omissions or for results obtained by the use of such information. £10 before and after the change in the exchange Whether changes in exchange rates affect prices, rate, it reduces the exporter’s revenue and profit.5 sales, and profits of exporters and importers Similarly, prices, sales, revenue, and profits of depends on whether changes in exchange rates importers are also affected by unexpected changes really make a firm’s goods cheaper or more exp- in exchange rates. ensive to buyers. For example, if a decrease in the Tables 1.2 and 1.3 provide some examples of value of the British pound from $1.5/£ to $1.4/£ companies whose profits have been affected by occurs while the price of a bottle of whiskey for changes in exchange rates. The examples indicate export from Scotland goes from £10 to £10.71, that effects can be substantial viewed both abso- a bottle of whiskey will continue to cost $15 in the lutely and relative to net income. Some companies, United States. This is because the pound price such as Ford Motor Company, have made foreign multiplied by the exchange rate, which gives the exchange gains while making losses overall. The dollar price, is unchanged. Our example shows that power of exchange rates to affect the bottom line in order to determine the effect of a change in and even the survival of companies is also illustrated exchange rates, we must examine inflation and in Exhibit 1.1. how inflation and exchange rates are related. This requires that we study international finance at the 5 In our whiskey example, the dollar price might in reality level of the economy as well as at the level of the increase by less than the change in the exchange rate. As is shown in Chapter 11, the amount of ‘‘pass through’’ of individual firm. changes in exchange rates reaching the buyer depends on The risk faced by exporters and importers the elasticity of demand, use of tradable inputs, and so on. resulting from the impact of exchange rates on &6  THE WORLD OF INTERNATIONAL FINANCE & Table 1.3 Selected foreign exchange losses, 2001: millions of US dollars Company Country Loss Net Inc. (Loss) Industry Telefonica Spain 697 1,875 Telecommunications Koninklijke Holland 279 984 Publishing Sony Japan 239 115 Music/Electronics United Pan Europe Holland 153 (3,935) Communications Turkcell Iletisim Turkey 151 (187) Telecommunications United Global Com. USA 148 (4,494) Communications Exxon Mobil USA 142 15,320 Energy General Motors USA 107 601 Transport Manuf. Portugal Telecom Portugal 106 273 Telecommunications Alcatel France 105 4,418 Telecommunications Alberta Energy Canada 71 517 Energy Lucent USA 58 (16,198) Telecommunications BASF Germany 56 5,214 Chemical Bell Canada Canada 39 235 Telecommunications Pfizer USA 33 7,788 Pharmaceuticals Monsanto USA 32 5,462 Agricultural Supply Abbot USA 31 16,285 Health Shell UK/Holland 30 135,211 Energy Dow Chemical USA 24 27,805 Chemical Source: COMPUSTAT, 2003. Information contained in this document is subject to change without notice. Standard and Poor’s assumes no responsibility or liability for any errors or omissions or for results obtained by the use of such information. prices, sales, and profits is only one, albeit probably imposition of nontariff barriers such as quality the most important, of the additional risks of requirements that are really designed to give international trade versus domestic trade. Another domestic firms an advantage. risk of international trade is country risk. This Practices have evolved and markets have devel- includes the risk that, as a result of war, revolution, oped which help firms cope with many of the added or other political or social events, a firm may not be risks of doing business abroad. For example, special paid for its exports: many exporters extend trade types of foreign exchange contracts have been credit to buyers. Country risk applies to foreign designed to enable importers and exporters to investment as well as to credit granted in trade, and hedge, or cover, some of the risks from unex- exists because it is difficult to use legal channels or pected changes in exchange rates. Similarly, export reclaim assets when the investment is in another credit insurance and letters of credit have political jurisdiction. Furthermore, foreign com- been developed to reduce risks of nonpayment panies may be willing but unable to pay because, for when granting trade credit to foreign buyers. With example, their government unexpectedly imposes international trade playing a growing role in just currency exchange restrictions. Other country- about every nation, it is increasingly important related risks of doing business abroad include that we learn about the risk-reducing instruments uncertainty about the possible imposition or change and practices. We must also learn about the funda- of import tariffs or quotas, possible changes in mental causes of the special risks of international subsidization of local producers, and possible trade. These are two important topics of this book. 7& THE WORLD OF INTERNATIONAL FINANCE EXHIBIT 1.1 CURRENCY MATTERS: CORPORATE EXPERIENCES News reports over the years have been full of 1985, the strong US dollar cost the company accounts of companies that have suffered huge losses $3.5 billion in before-tax earnings. Subsequent or enjoyed great gains from exchange rate move- weakening of the dollar helped reverse the losses, ments. The very fact that foreign exchange losses and showing that failure to fully hedge may or may not gains frequently make the business headlines is proof be harmful. in itself that companies have not hedged their foreign “ In 1986, Japan’s largest camera producer exchange exposure, or if they have hedged, that the reported a more than two-thirds reduction in hedges have been incorrectly designed. Consider, for profit attributed to a strong Japanese yen. example, the following reports during just one short period of time: It is worth mentioning that in the case of Volkswagen, the apparent fraud was the result of a failure of “ In 1985, the same year that Volkswagen pro- managers in charge of reducing the company’s for- duced its 50 millionth car, the company found eign exchange risk – or more precisely its itself apparently defrauded to the tune of nearly ‘‘exposure,’’ a term we define later – to take the half a billion Deutschmarks. At the time this was steps they were supposed to. Indeed, forged docu- equivalent to approximately a quarter of a billion ments were used to hide the absence of the appro- dollars. The problem was that the US dollar fell priate steps. The Volkswagen experience is a vivid well below what it could have been sold for, and example of how costly it can be not to apply some as required by company policy, by using an of the principles in this book, even though in appropriate foreign exchange contract. The Volkswagen’s case top management knew very well foreign exchange loss that ensued was enough what should be done. Indeed Volkswagen had very to wipe out the profit from a calendar quarter of strict rules that all foreign exchange exposure be global operations. hedged. Unfortunately, those responsible for putting “ In the case of BOC, a British producer of gases the rules into effect ignored top management’s for industry, a foreign exchange gain of nearly instructions. seventeen million pounds was made by using a  Hedging is action taken to reduce foreign exchange foreign exchange contract to sell the entire year’s exposure, and is discussed later at length, especially in revenues for 1985 at a substantially higher price Chapters 12–15. than would have been received by selling the Source: Based on information in ‘‘Companies and foreign exchange as it was received. Currencies: Payment by Lottery,’’ The Economist, April 4, “ The US photographic company, Eastman-Kodak, 1987, p. 8, and ‘‘Ex-VW Official is Arrested in Fraud Case,’’ estimated that in the few years leading up to The Wall Street Journal, April 8, 1987, p. 27. Increased globalization of financial and businesses (see Exhibit 1.2).6 At times, the impo- real-asset markets rtance of overseas investments and investors has swelled to overshadow that of domestic investments Alongside the growing importance of international and investors. For example, there have been periods trade, there has been a parallel growth in the when purchases of US bills and bonds by Japanese, importance of foreign investment in the money market, the bond market, the stock market, the 6 Some measures of globalization of financial markets are real-estate market, and the market for operating provided in Exhibit 1.2. &8  THE WORLD OF INTERNATIONAL FINANCE EXHIBIT 1.2 GETTING A GRIP ON GLOBALIZATION A definition of globalization that many economists countries’ securities, this would be a sign that like is that ‘‘globalization is a shrinkage of economic globalization has not come very far. However, if space.’’ In terms of economic arrangements, distance investors are internationally diversified, this is evi- does not matter as much as it used to. dence that globalization has occurred. The actual This book is an example of globalization. The holdings of foreign versus domestic securities would author lives in Canada. The book is published by need to be compared to the importance of each a British publisher. The copyediting was done in India. country in the global financial market. For example, if You, the reader, could be sitting down to learn inter- a country is 10 percent of the world market, complete national finance just about anywhere. Was all this globalization would mean that only 10 percent of difficult to achieve? The answer is ‘‘no, not at all!’’ investments should be in domestic securities. The With e-mail, fax, couriers and multinational pub- more domestic holdings exceed this proportion, the lishing houses it is scarcely more difficult to do this further globalization still has to go (as we shall across the globe than to try and do it all in a single see later in this book, on this measure globalization country. Indeed, there are benefits from taking has scarcely begun). advantage of the forces of globalization. There are yet further ways to measure the extent of If there is one industry where globalization can globalization of financial markets. One way is to see if progress most easily, possibly even easier than in listing of a stock on a foreign stock exchange has any textbook publishing, it is in the area of banking and influence on its price. It should not if the world is truly finance. This is because the costs of moving money global, because in such a world the security could be from place to place can be inconsequential compared bought in its home country, wherever the investors to transportation costs in, say, the oil or the auto- reside. Similarly, if the world is really just one single, mobile industry. The result is that returns offered to seamless global financial market as much of the investors have to be just about the same in every rhetoric would suggest, central banks would have country, at least after possible changes in exchange little or no effect on inv