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P A R T 0 N E 1

Foundations of International Financial Management 1

BRIEF CONTENTS 1

Foundations of International Financial Management 1

1 Globalization and the Multinational Firm, 2

GLOBALIZATION AND THE MULTINATIONAL FIRM, 2

What's Special about International Finance? 5

Market Imperfections, 6

Foreign Exchange and Political Risks, 6

Expanded Opportunity Set, 8

Goals for International Financial Management, 9

Globalization of the World Economy: Recent Trends, 10

Privatization: The Theme of the Nineties, 13

INTERNATIONAL FINANCE IN PARCTICE BOXES 14

What Is Privatization, Anyway? 14

Multinational Corporations, 16

Multinationals Spur Surge in Investment, 18

Organization of the Text, 18

Summary, 23

Appendix IA: Gains from Trade: The Theory of Comparative Advantage, 28

INTERNATIONAL MONETARY SYSTEM, 31

2 International Monetary System, 31

Bimetallism: Before 1875, 32

Evolution of the International Monetary System, 32

Classical Gold Standard: 1875--1914, 33

Interwar Period: 1915--1944, 35

Bretton Woods System:1945--1972, 36

The Flexible Exchange Rate Regime:1973--Present, 39

The Current Exchange Rate Arrangements, 41

European Monetary System, 44

Europe: Unification for the Favored Few, 48

The New World Order of Finance, 50

The Mexican Peso Crisis, 50

Fixed versus Flexible Exchange Rate Regimes, 52

Summary, 54

Mini Case: The ProSPect of the European Monetary union(EMU), 56

C h a p t e r 3 58

BALANCE OF PAYMENTS, 58

3 Balance of Payments, 58

Balance-of-Payments Accounting, 59

Balance-of-Payments Accounts, 60

The Current Account, 60

The Capital Account, 63

Statistical Discrepancy, 65

Official Reserves Account, 65

The Balance-of-Payments Identity, 66

The Balance-of-Payments Trends in Major Countries. 68

Will the Party Fizzle When the Sake Runs Dry? 70

Summary, 72

Mini Case: Mexico's Balance-of-Payments Problem. 74

C h a p t e r 4 76

THE MARKET FOR FOREIGN EXCHANGE, 76

4 The Market for Foreign Exchange, 76

Function and Structure of the FOREX Market, 77

FX Market ParticiPants, 78

CorresPondent Banking Relationships. 79

Fearless Dealers, 80

The Spot Market, 82

Spot Rate Quotations, 82

The Bid-Ask Spread, 83

SPot FX Trading. 84

Cross Exchange Rate Quotations. 85

Young Traders Run Currency Markets, 86

Alternate Expressions for the Cross-Exchange Rate, 88

The Cross-Rate Trading Desk, 89

Triangular Arbitrage, 90

The Forward Market, 93

Forward Rate Quotations, 94

Long and Short Forward Positions, 95

Forward Cross Exchange Rates, 96

Swap Transactions, 96

Forward Premium, 98

Summary, 99

Mini Case: Shrewsbury Herbal Products, Ltd., 101

C h a p t e r 5 104

INTERNATIONAL PARITY RELATIONSHIP AND FORECASTING 104

FOREIGN EXCHANGE RATES, 104

5 International Parity Relationships and Forecasting Foreign Exchange Rates, 104

Interest Rate Parity, 105

Covered Interest Arbitrage, 107

Interest Rate Parity and Exchange Rate Determination, 110

Reasons for Deviations from Interest Rate Parity 111

Purchasing Power Parity 114

Purchasing Power Parity and Exchange Rate Determination, 115

Equilibrium in Currency Markets? 116

PPP Deviations and the Real Exchange Rate, 117

Evidence on Purchasing Power Parity. 118

The Fisher Effects, 122

Forecasting Exchange Rates, 123

Efficient Market Approach. 124

Fundamental Approach, 125

Technical Approach, 126

Performance of the Forecasters, 127

Summary, 129

World Financial Markets and Institutions 134

P A R T T W 0 134

INTERNATIONAL BANKING AND MONEY MARKET, 136

C h a p t e r 6 136

6 International Banking and Money Market, 136

World Financial Markets and Institutions 136

P A R T T W 0 136

International Banking Services, 137

The World's Largest Banks, 137

Types of InternationaI Banking Offices, 140

Reasons for International Banking, 140

CorresPondent Bank, 141

Representative Offices, 141

Foreign Branches, 141

Subsidiary and Affiliate Banks, 142

Edge Act Banks, 143

Offshore Banking Centers, 143

International Banking Facilities, 144

Capital Adequacy Standards, 144

International Money Market, 146

Eurocurrency Market, 146

Illustrated Mini Case: Eurocurrency Creation, 149

Eurocredits, 151

Forward Rate Agreements, 153

Euronotes, 154

Contents 155

Euro-Medium-Term Notes, 155

Eurocommercial PaPer 155

History, 156

International Debt Crisis, 156

Debt-for-Equity Swaps. 158

LDC Lenders Should Have Listened to David Hume, 158

The Solution: Brady Bonds, 161

The Recent Situation, 162

Summary, 163

Mini Case Detroit Motors' Latin American Expansion, 166

C h a g t e r 7 169

INTERNATIONAL BOND MARKET, 169

7 International Bond Market, 169

The World's Bond Markets: A Statistical Perspective, 170

Foreign Bonds and Eurobonds, 170

Bearer Bonds and Registered Bonds. 172

National Security Regulations. 172

Withholding Taxes, 173

Other Recent Regulatory Changes, 173

Global Bonds. 173

Types of Instruments, 174

Straight Fixed-Rate issues. 174

Floaring-Rate Notes, 174

Equity-Related Bonds, 175

Zero-Coupon Bonds. 175

Dual-Currency Bonds, 176

Currency Distribution, Nationality, and Type of Issuer, 177

Composite Currency Bonds, 177

International Bond Market Credit Ratings, 179

Sara Lee Corp. Offers 3-Year Eurobonds at 6%, 180

Primary Market. 183

Eurobond Market Structure and Practices, 183

Secondary Market, 184

Clearing Procedures, 186

International Bond Market Indexes, 186

Summary, 190

8 International Equity Markets, 194

C h a p t e r 8 194 195

INTERNATIONAL EQUITY MARKETS, 195

A Statistical Perspective, 195

Market Capitalization of Developed Countries, 195

Market CaPitalization of Developing Countries, 195

Measures of Liquidity, 198

Measures of Market Concentration, 200

International Equity Market Benchmarks, 200

Market Structure, Trading Practices, and Costs, 202

Trading in International Equities, 207

Magnitude of International Equity Trading, 211

Cross-Listing of Shares, 211

Yankee Stock Offerings, 214

Eurolist, 214

American Depository Receipts, 215

Factors Affecting International Equity Returns, 217

Macroeconomic Factors, 217

Buying Foreign Stocks From U.S. Brokers Gets Easier, 218

Exchange Rates, 218

Industrial Structure, 219

Summary. 220

FUTURES AND OPTIONS ON FOREIGN EXCHANGE 225

C h a p t e r 9 225

9 Futures and Options on Foreign Exchange, 225

Futures Contracts: Some Preliminaries, 226

Currency Futures Markets, 228

Basic Currency Futures Relationships, 230

Eurodollar Interest Rate Futures Contracts, 231

Options Contracts:Some Preliminaries, 233

Currency Options Markets, 234

Commodities: Why Isn't Currency Turmoil Sparking Future Boom? 236

Currency Futures Options, 237

Basic Option-Pricing Relationships at Expiration, 238

American Option-Pricing Relationships, 241

European Option-Pricing Relationships, 242

A European Option-Pricing Formula, 244

Empirical Tests of Currency Options, 245

Summary, 246

Mini Case. The Options Speculator, 248

C h a p t e r 1 0 251

CURRENCY AND INTEREST RATE SWAPS, 251

10 Currency and Interest Rate Swaps, 251

Some Useful Definitions, 252

Size of the Swap Market, 252

The World Bank's First Currency Swap, 253

Basic Interest Rate Swap, 254

Interest Rate Swaps, 254

The Swap Bank, 254

Currency Swaps, 257

Parallel Loans, 257

Back-to-Back Loans, 259

Institutional Difficulties of Parallel and Back-to-Back Loans, 259

Basic Currency Swap, 260

Swap Market Quotations, 264

Variations of Basic Currency and Interest Rate Swaps. 264

Risks of Interest Rate and Currency Swaps, 265

Eli Lilly and Company: The Case of the Appreciating Yen, 266

Is the Swap Market Efficient? 266

Concluding Points about Swaps, 267

Summary. 268

Mini Case The Centralia Corporations Currency Swap. 271

11 International Portfolio Investments, 273

C h a p t e r 1 1 275

International Correlation Structure and Risk Diversification, 275

Optimal International Portfolio Selection, 277

Effects of Changes in the Exchange Rate, 284

International Bond Investment, 286

International Mutual Funds: A Performance Evaluation, 287

International Diversification through Country Funds, 289

International Diversification with ADRs, 293

Live Here, Invest Abroad, 294

Why Home Bias in Portfolio Holdings? 296

Stay-at-Home Shareholders, 298

Summary. 300

Mini Case: Solving for the OPtimal International Portfolio, 303

Appendix 11A: International Investment with Exchange Risk Hedging 307

APPendix 11B: Solving for the Optimal Portfolio, 308

C h a p t e r 1 2 312

ANAGEMENT OF ECONOMIC EXPOSURE, 312

12 Management of Economic Exposure, 312

Foreign Exchange Exposure and Management 312

P A R T T H R E E 312

Three Types of Exposure, 313

How to Measure Economic Exposure, 315

U.S. Firms Feel the Pain of Peso's Plunge, 316

Operating Exposure: Definition, 320

Illustration of Operating Exposure, 321

Determinants of OPerating Exposure, 324

Selecting Low-cost Production Sites, 326

Managing Operating Exposure, 326

Flexible Sourcing Policy, 327

The Strong Yen and Toyota's Choice, 327

Financial Hedging, 328

Diversification of the Market, 328

R D Efforts and Product Differentiation, 328

Illustrated Mini Case:Exchange Risk Management at Merck, 329

Step 1: Exchange Forecasting, 329

SteP 2: Assessing Strategic Plan Impact, 330

SteP 3: Deciding Whether to Hedge, 330

SteP 4: Selecting the Hedging Instruments, 330

SteP 5: Constructing a Hedging Program. 330

Summary, 331

Mini Case: Economic Exposure of Albion Computers PLC, 333

13 Management of Transaction Exposure, 335

C h a p t e r 1 3 336

Forward Market Hedge, 336

Money Market Hedge, 339

Options Market Hedge, 340

Hedging Contingent Exposure, 343

Hedging Recurrent Exposure, 344

Hedging through Invoice Currency, 345

Hedging via Lead and Lag, 346

Exposure Netting, 346

Should the Firm Hedge? 347

TO Hedge or Not to Hedge, 348

What Risk Management Products Do Firms Use? 351

Summary, 352

Mini Case: Western Mining's Currency Exposure 353

Management, 355

14 Management of Translation Exposure, 363

MANGEMENT OF TRANSLATION EXPOSURE, 363

Current/Noncurrent Method, 364

Translation Methods, 364

Monetary/Nonmonetary Method, 364

Current Rate Method, 365

Temporal Method, 365

Financial Accounting Standards Board Statement 8, 367

Financial Accounting Standards Board Statement 52, 368

The Mechanics Of the FASB 52 Translation Process, 369

Highly Inflationary Economies, 370

Illustrated Mini Case: Consolidation of Accounts According to FASB 52: The Centralia Corporation, 372

Translation ExPosure versus Transaction ExPosure, 377

Management of Translation Exposure, 377

Balance Sheet Hedge, 378

Hedging Translation ExPosure, 378

Derivatives Hedge, 379

Empirical Analysis of the Change frOm FASB 8 to FASB 52, 380

Translation ExPosure versus Operating ExPosure, 380

Summary, 381

Mini Case: Sundance Sporting Goods. Inc., 383

Financial Management of the Multinational Firm 388

P A R T F 0 U R 388

15 Foreign Direct Investment, 388

C h a p t e r 15 388

FOREIGN DIRECT INVESTMENT, 388

Global Trends in FDI, 389

Why Do Firms Invest Overseas? 394

Trade Barriers, 394

Imperfect Labor Market, 395

Vertical Integration, 396

Intangible Assets, 396

Product Life Cycle, 397

Linear Sequence in Manufacturing: Singer and Company, 398

Shareholder Diversification Services. 399

Cross-Border Acquisitions, 401

MCI's New Extension: Merging with British Telecom Gives the American Upstart the Muscle to Attack Local Phone Markets, 404

Political Risk and FDI, 407

Stories Past and Present, 408

Summary, 416

16 International Capital Structure and the Cost of Capital, 420

C h a p t e r 1 6 420

INTERNAIONAL CAPITAL STRUCTURE AND THU COST OF CHPITAL, 420

Cost of Capital, 421

The U.S. Welcomes the Alien Invasion, 422

Cost of CaPital in Segmented versus Integrated Markets, 425

Does the Cost of Capital Differ among Countries? 426

Cross-Border Listings of Stocks, 430

Capital Asset Pricing under Cross-Listings, 432

The Effect of Foreign Equity Ownership Restrictions, 436

Illustrated Mini Case: Nestle, 437

Pricing-to-Market Phenomenon, 437

Asset Pricing under Foreign Ownership Restrictions, 438

The Financial Structure of Subsidiaries, 440

Summary, 443

C h a p t e r 1 7 447

Appendix 16 A: Pricing of Nontradable Assets, 447

17 International Capital Budgeting, 448

INTERNATIONAL CHPITAL BUDGETING, 448

Review of Domestic Capital Budgeting, 449

The Adjusted Present Value Model, 450

Capital Budgeting from the Parent Firm's Perspective, 452

Generality of the APV Model, 455

Estimating the Future Expected Exchange Rate, 456

Illustrated Mini Case: The Centralia Corporation, 456

Sensitivity Analysis, 460

Risk Adjustment in the Capital Budgeting Analysis, 460

Summary, 461

Mini Case: Dorchester, Ltd., 462

MULTINATIONAL CASH MANHGEMENT, 465

18 Multinational Cash Management, 465

C h a p t e r 1 8 465

Illustrated Mini Case: Teltrex's Cash Management System, 466

The Management of International Cash Balances, 466

Netting Systems, 467

Centralized Cash Depository, 469

Bilateral Netting of Internal and External Net Cash Flows 472

Reduction in Precautionary Cash Balances, 473

Cash Management Systems in Practice, 474

Transfer Pricing and Related Issues, 475

Disciplining European Cash: Currency Violation Spurs Proactive Cash Management, 476

Illustrated Mini Case: Mintel Products Transfer Pricing Strategy, 478

Low versus High Markup Policy, 478

Exchange Restrictions, 479

Differential Income Tax Rates, 479

Regulations Affecting Transfer Prices. 480

Import Duties, 481

Tug-of-Taxes: International Enforcers May be Pulling in the Wrong Direction, 482

Unbundling Fund Transfers, 484

Miscellaneous Factors, 485

Blocked Funds, 486

Summary, 487

Mini Case I: Efficient Funds Flow at Eastern Trading Company, 489

Mini Case 2: Eastern Trading Company's Optimal Transfer Pricing Strategy, 489

Mini Case 3: Eastern Trading Company's New MBA, 490

19 Exports and Imports, 492

EXPORTS AND IMPORTS, 492

C h a p t e r 1 9 492

A Typical Foreign Trade Transaction, 493

Forfaiting, 496

The ExPort-Import Bank and Affiliated Organizations, 497

Government Assistance in Exporting, 497

Countertrade, 498

Forms of Countertrade, 499

Some Generalizations about Countertrade, 500

Summary, 501

C h a p t e r 2 0 505

20 International Tax Environment, 505

INTERNATIONAL TAX ENVIRONMENT, 505

The Objectives of Taxation, 506

Tax Neutrality, 506

Income Tax, 507

Types of Taxation, 507

Tax Equity, 507

Withholding Tax, 509

Value-Added Tax, 511

The Rise and Rise of VAT 512

National Tax Environments, 512

Worldwide Taxation, 513

Foreign Tax Credits, 514

Territorial Taxation, 514

Branch and Subsidiary Income, 515

Organizational Structures for Reducing Tax Liabilities. 515

Payments to and from Foreign Affiliates, 517

Tax Havens, 518

Foreign Sales Corporation, 519

Controlled Foreign Corporation, 519

U.S. Possessions Corporations, 520

Summary, 521

GLOSSARY, 524

INDEX, 532