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Unformatted text preview: 991.qxd 7/15/2006 11:41 AM Page 1 Batch number: 1 CIRCULATED Date: SEEN BY DESK EDITOR: REVISE NEEDED Initial: Date: APPROVED FOR PRESS BY DESK EDITOR Initial: Date: Back board: ❑ ISBN ❑ Barcode Fourth edition INTERNATIONAL FINANCE Maurice D. Levi CHECKLIST (must be completed before press) (Please cross through any items that are not applicable) Front board: Spine: ❑ Title ❑ Title ❑ Subtitle ❑ Subtitle ❑ Author/edited by ❑ Author/edited by ❑ Series title ❑ Extra logo if required ❑ Extra logo if required General: ❑ Book size ❑ Type fit on spine International Finance Maurice D. Levi ISBN 978-0-415-30899-1 ,!7IA4B 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 interests 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 Preface 1 THE WORLD OF INTERNATIONAL FINANCE Unique dimensions of international finance The benefits of studying international finance The growing importance of international finance Topics covered in this book Summary Review questions Assignment problems Bibliography Parallel material for case courses Appendix A Appendix B xiii xviii 1 1 1 2 13 17 17 18 18 19 19 22 PART I THE MARKETS FOR FOREIGN EXCHANGE 2 AN INTRODUCTION TO EXCHANGE RATES The foreign bank note market The spot foreign exchange market Organization of the interbank spot market Direct versus indirect exchange and cross exchange rates Summary Review questions Assignment problems Bibliography 3 FORWARD EXCHANGE What is forward foreign exchange? Forward exchange premiums and discounts Forward rates versus expected future spot rates Payoff profiles on forward exchange Outright forward exchange and swaps 27 29 29 32 32 43 50 51 51 52 53 53 54 56 56 58 vii & CONTENTS The flexibility of forward exchange Forward quotations Summary Review questions Assignment problems Bibliography 4 CURRENCY FUTURES AND OPTIONS MARKETS Currency futures Currency options Forwards, futures, and options compared: a summary Summary Review questions Assignment problems Bibliography Appendix A 60 61 65 66 66 67 68 68 75 85 86 87 88 89 89 PART II THE DETERMINATION OF EXCHANGE RATES 5 THE BALANCE OF PAYMENTS Influences on currency supply and demand Principles of balance-of-payments accounting Balance-of-payments entries and the factors that influence them Implications of the balance-of-payments accounting identity The net international investment position Objectives of economic policy Summary Review questions Assignment problems Bibliography 6 SUPPLY-AND-DEMAND VIEW OF EXCHANGE RATES Imports, exports, and exchange rates The factors affecting exchange rates The stability of exchange rates Short-run versus long-run trade elasticities and the J curve Summary Review questions Assignment problems Bibliography Appendix A 95 97 97 98 99 108 111 113 114 116 116 117 119 120 122 130 133 135 136 136 137 137 PART III THE FUNDAMENTAL INTERNATIONAL PARITY CONDITIONS 141 7 THE PURCHASING-POWER-PARITY PRINCIPLE 143 The law of one price Absolute (or static) form of the PPP condition The relative (or dynamic) form of PPP 143 144 145 & viii CONTENTS Efficient markets (or speculative) form of PPP The empirical evidence on PPP Reasons for departures from PPP Statistical problems of evaluating PPP The practical importance of PPP Summary Review questions Assignment problems Bibliography 8 INTEREST PARITY The investment and borrowing criteria The covered interest-parity condition Combining PPP and interest parity Why covered interest differences persist Summary Review questions Assignment problems Bibliography 147 148 151 152 154 155 156 156 157 159 160 166 169 171 184 185 186 187 PART IV MANAGING FOREIGN EXCHANGE RISK AND EXPOSURE 9 FOREIGN EXCHANGE EXPOSURE AND RISK The importance of understanding risk and exposure and measuring them The nature of exchange-rate risk and exposure Examples of foreign exchange exposure Exposure as a regression slope Definition of foreign exchange risk Exposure, risk, and the parity relationships Summary Review questions Assignment problems Bibliography 10 11 189 191 191 192 193 198 204 205 211 213 213 214 ACCOUNTING EXPOSURE VERSUS REAL EXPOSURE 216 Accounting principles Real changes in exchange rates Summary Review questions Assignment problems Bibliography 216 220 226 227 227 228 OPERATING EXPOSURE 230 Operations affected by exchange rates The exporter The importer Summary of effects of exchange rates on exporters and importers Effect of currency of invoicing and forward hedging Measuring exposure: an alternative approach Summary 230 231 240 244 244 249 251 ix & CONTENTS Review questions Assignment problems Bibliography 12 13 252 253 254 HEDGING RISK AND EXPOSURE 256 Whether to hedge: managerial hedging versus shareholder hedging Hedging of receivables and payables The cost of forward hedging The benefit of forward hedging Financial engineering: payoff profiles of different hedging techniques Having a company hedging policy Summary Review questions Assignment problems Bibliography 256 259 260 264 272 276 276 277 278 279 EXCHANGE-RATE FORECASTING AND SPECULATION 280 Speculation Market efficiency Exchange-rate forecasting Summary Review questions Assignment problems Bibliography 280 283 288 300 302 302 303 PART V INTERNATIONAL INVESTMENT AND FINANCING 14 15 16 305 CASH MANAGEMENT 307 The objectives of cash management Investment and borrowing choices with transaction costs International dimensions of cash management Summary Review questions Assignment problems Bibliography 307 308 310 319 320 320 321 PORTFOLIO INVESTMENT 322 The benefits of international portfolio investment International capital asset pricing Bonds and international portfolio diversification Settlements of international portfolio investments Summary Review questions Assignment problems Bibliography 322 331 339 341 341 343 343 344 CAPITAL BUDGETING FOR FOREIGN INVESTMENTS 346 Selecting projects Difficulties in evaluating foreign projects 346 348 &x CONTENTS Cash flows: home versus foreign perspectives Discount rates: corporate versus shareholder perspectives The adjusted-present-value technique Selecting the appropriate discount rates An example Actual practice of capital budgeting Summary Review questions Assignment problems Bibliography Appendix A The different forms of taxes Organizational structures for reducing taxes Appendix B 17 18 349 351 351 354 356 360 361 362 362 363 364 364 367 369 THE GROWTH AND CONCERNS ABOUT MULTINATIONALS 373 The growth of MNCs Special issues facing MNCs: transfer pricing Special issues facing MNCs: country risk Problems and benefits from the growth of MNCs Transnational alliances Summary Review questions Assignment problems Bibliography 373 381 384 390 393 393 395 395 396 INTERNATIONAL DIMENSIONS OF LONG-TERM FINANCING 397 Equity financing Bond financing Bank financing, direct loans, and the like Government and development-bank lending Other factors affecting the financing of subsidiaries Financial structure Summary Review questions Assignment problems Bibliography 397 402 410 413 413 414 417 418 418 419 PART VI INSTITUTIONAL STRUCTURE OF INTERNATIONAL TRADE AND FINANCE 19 20 421 MULTINATIONAL BANKING 423 The Eurodollar and offshore currency markets Multinational banking Summary Review questions Assignment problems Bibliography 423 431 441 442 442 443 INSTRUMENTS AND INSTITUTIONS OF INTERNATIONAL TRADE 445 Extra dimensions of international trade International trade involving letters of credit: an overview of a typical transaction 445 445 xi & CONTENTS Alternative payment and guaranteeing procedures The financing of international trade Countertrade The institutions regulating international trade Summary Review questions Assignment problems Bibliography 450 452 456 459 463 464 464 465 PART VII THE INTERNATIONAL MACROECONOMIC ENVIRONMENT: THEORIES AND PRACTICES 21 22 23 467 ASSET-BASED THEORIES OF EXCHANGE RATES 469 Stock versus flow theories of exchange rates The monetary theory of exchange rates The asset approach to exchange rates The portfolio-balance approach to exchange rates Theories of exchange-rate volatility Summary Review questions Assignment problems Bibliography 469 469 474 475 479 483 484 484 485 ALTERNATIVE SYSTEMS OF EXCHANGE RATES 487 The classical gold-standard system The Bretton Woods and dollar standards The European monetary system (EMS) Hybrid systems of exchange rates Target zones Summary Review questions Assignment problems Bibliography Appendix A Appendix B 488 491 496 499 502 504 506 506 507 508 511 THE INTERNATIONAL FINANCIAL SYSTEM: PAST, PRESENT, AND FUTURE 514 The past The present The future Degree of exchange-rate flexibility: fixed versus flexible exchange rates Summary Review questions Assignment problems Bibliography 514 529 529 536 543 544 545 546 Glossary Name index Subject index & xii 547 573 578 Illustrations FIGURES 1.1 1.2 1B.1 1B.2 2.1 2.2 2.3 2.4 2.5 3.1 3.2 4.1 4.2 4.3 4.4 4.5 4A.1 Percentage of GDP arising from exports International investment position of the United States The gain from the better allocation of capital Utility from different consumption patterns Daily turnover in the US foreign exchange market, 1986–2001 Organization of the foreign exchange market Interbank spot and selected forward exchange rates Direct versus indirect exchange: zero transaction costs Direct versus indirect exchange: nonzero transaction costs Payoff profile on forward contract to buy ¤1 million Payoff profile on forward contract to sell ¤1 million Prices of principal CME currency futures: September 18, 2003 Payoff profile for purchase of euro futures contract Premiums on principal CME options on currency futures: September 18, 2003 Payoff profiles of buyer and writer of euro call option for ¤125,000 Payoff profiles of buyer and writer of euro put option for ¤125,000 Equivalence of buying foreign currency European call and selling put, versus buying the foreign currency forward 4A.2 Equivalence of selling foreign currency European call and buying put, versus selling the foreign currency forward 6.1 Deriving the supply of pounds 6.2 Deriving the demand for pounds 6.3 The exchange rate from imports and exports 6.4 Deriving the demand for imports 6.5 Deriving the export supply curve 6.6 Inflation in relation to supply and demand 6.7 Inflation and exchange rates 6.8 Currency supply and import elasticity 6.9 Stability of foriegn exchange markets 6.10 The J curve 7.1 US–Mexican inflation and the peso–dollar exchange rate 8.1 Dollar versus hedged pound investments 8.2 Dollar versus hedged pound borrowing 8.3 Covered interest arbitrage: dollar borrowing and pound investing 3 10 23 24 33 35 41 44 47 58 59 69 74 76 84 85 90 90 121 122 123 124 125 126 127 131 132 134 154 161 164 165 xiii & ILLUSTRATIONS 8.4 8.5 8.6 8.7 8.8 9.1 11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 11.10 12.1 12.2 14.1 14.2 15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 17.1 18.1 19.1 19.2 20.1 20.2 20.3 20.4 20.5 21.1 21.2 21.3 22.1 22.2 22.3 22.4 23.1 & xiv The covered interest parity diagram The interdependence of exchange rates, interest rates, and inflation rates One way and round-trip interest arbitrage Interest parity in the presence of transaction costs, political risk, or liquidity premiums A more roundabout one-way arbitrage Exposure as the slope of a regression line Exporter and devaluation in a competitive market Exporter and devaluation in a competitive market: effect of cost increases Devaluation and the demand curve Exporter and devaluation in an imperfectly competitive market Exporter and devaluation in an imperfectly competitive market: foreign-currency units The importer and a devaluation Importer and devaluation in foreign-currency units Importer of inputs and devaluation Exporter with payables exposure: dollar accounting The J curve Payoff profiles, payables exposure, and resulting exposure with forward and futures contracts Payoff profiles from option hedges Example of Navistar International’s foreign exchange netting system Digital Equipment’s weekly cash cycle Correlations between US and other countries’ stock markets, US dollars, 1980–90 Correlations between Japanese and other countries’ stock markets, Japanese yen, 1980–90 Correlations between British and other countries’ stock markets, British pounds, 1980–90 The size of the gain from international diversification Local-market versus exchange-rate components of volatility of US dollar values of non-US stocks, 1970s and 1980s The advantages of international diversification with and without exchange risk The relationship between expected return and total risk Efficiency frontier of global stocks, US dollar, 1980–90 Contribution of bonds to the globally efficient frontier, US dollars, 1980–90 Euromoney’s country-risk rating scheme Parallel loans and credit swaps Deposit and asset shares of foreign banks in the United States, 1990–2001 Share of loans by foreign banks in the United States, 1990–2001 Application and agreement for documentary letter of credit The draft and banker’s acceptance The steps in international trade The steps involved in forfaiting The different forms of countertrade The portfolio-balance theory: effect of open-market operations Real income growth and the portfolio-balance theory Exchange-rate overshooting The workings of the gold-exchange and dollar standards The price-level adjustment mechanism of the gold-exchange and dollar standards Crawling peg Target zones for exchange rates Post-war changes in economic importance 167 171 174 175 178 199 232 235 236 237 239 241 243 244 246 246 273 275 316 318 323 324 324 327 328 330 333 334 341 386 412 432 432 447 448 449 454 458 476 478 480 493 495 500 503 530 ILLUSTRATIONS 23.2 23.3 23.4 US and Japanese trade balances, 1965–2002 US bilateral trade balance with China and Japan, 1985–2003 Stabilizing and destabilizing currency speculation 533 534 540 TABLES 1.1 1.2 1.3 1.4 1A.1 1A.2 2.1 2.2 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 4.3 4.4 4.5 4.6 4A.1 5.1 5.2 7.1 8.1 8.2 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 10.1 10.2 12.1 12.2 13.1 Aggregate international trade versus GDP Selected foreign exchange gains, 2001 Selected foreign exchange losses, 2001 The volatility of exchange rates The situation with no international trade Input/output under free trade Exchange rates on foreign bank notes (Traveler’s dollar – October 22, 2002) Geographical distribution of average daily foreign exchange turnover, April 2001 Foreign exchange net turnover by market segment: daily averages, April 2001 Per annum percentage premium (þ) or discount () on forward foreign exchange vis-a`-vis the US dollar Unanticipated changes in the spot exchange rate and gains or losses on forward purchase of ¤1 million at $1.15/¤ Unanticipated changes in the spot exchange rate and gains or losses on forward sale of ¤1 million at $1.15/¤ Foreign exchange derivative turnover by currency pair: daily turnover in April 2001 Bids and asks on pounds Settlements on a pound futures contract Realized spot rates and gains/losses on futures to buy euros Impact of variables affecting currency call and put option premiums Payoffs on purchase of euro call option Payoffs on purchase of euro put option Forwards, futures, and options compared European option put-call forward parity Summary format of the US balance of payments, 3rd quarter, 2002 International investment position of the United States year-end 2001 Average absolute deviations from PPP Exchange rates and interest rates on different currency-denominated 3-month bank deposits Points off the interest parity line Exposure on a contractual asset: euro bank deposit Exposure o...
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