International Financial and Risk

Management (LZACF305)
Dr. Benjamin Hammer
Department of Accounting and Finance
Lancaster University Management School
Module objectives

• Describe the structure of the international monetary system

• Analyse the relationships between interest rates, inflation rates
and exchange rates
• Explain the main determinants of exchange rate movements
and risk
• Deepen course participants understanding of derivatives by
applying basic concepts to foreign exchange futures, options
and other related instruments for risk management
• Explain the use of foreign exchange derivatives in the context of
corporation risk management
• Provide guidelines for corporate financial decision making in an
international context
Learning outcomes

• By the end of this module, students should:

– Be able to give reasoned analyses of developments in
international financial markets
– Be familiar with the valuation of foreign exchange futures, options
and other related financial instruments
– Understand the objectives of exchange-rate risk management
– Be familiar with the fundamentals of financing, investing, and risk
management in international financial markets
Readings

• Core textbook:
Sercu, Piet (2009), International Finance: Theory into Practice,
1st edition, Princeton University Press, Cambridge
OneSearch - Sercu, Piet (2009), International Finance: Theory
into Practice, 1st edition, Princeton University Press, Cambridge
(lancaster-university.uk)
Assessment

• The course is assessed with a combination of

– Coursework assignment (25%)
• Based on the groupwork
• Deadline is 15 December 2023 (13:00 CET)
– Summer exam (75%)
Contact details

• My e-mail address: [email protected]

• Office hours:
Fridays 11:00-13:00 CET
Please drop me a line in advance.
Practical information

• Lectures
– 2 compulsory 1-hour lectures every week
– Each week we will focus on 1 or 2 chapters from the textbook
• Tutorials
– One compulsory 1-hour tutorial per week
– First tutorial in week 2
– Exercises/readings based on the material from the previous
lectures have to be answered before attending the tutorials
Module outline

• Institutional aspects of international finance (week 1):

– Money, the international payment mechanism, the balance of
payments, exchange rate regimes
• Currency markets: spot, forward, futures, swap & option
markets (weeks 2-6):
– Institutional characteristics of these markets
– Definition of the instruments traded on these markets
– Arbitrage relations across markets and pricing
– Usefulness of these markets for non-financial corporations
Module outline cont’d

• Corporate risk management (week 7):

– Value-relevance of corporate hedging for shareholders
– Implementation of feasible hedging strategies
• International capital budgeting (weeks 8-9):
– Cost of capital of an international project: International CAPM
– Discounting of international cash flows
• Remaining applications, course summary, and exam info (week
10)
Historical daily volume (mid-2010s)
Outline of Week 1

• Essential reading: Chapter 2 of Sercu (2009).

• Topics:
– Money: What is it? Why do we have money? How has money
evolved over time, and why in this particular way?
– Banking system: How did banks create money? What is the
difference between a central bank and a commercial bank? How
do banks help to make international transactions?
– Balance of Payments: What is it? How exactly does it work?
– Exchange rate regimes: Gold parity, fixed exchange rates,
multilaterally fixed exchange rates.
The Role and History of Money

• Why does money exist? → Money is useful & convenient.

– Assume no money exists (barter economy). A hungry blacksmith,
who has specialized in the production of horse shoes, wants to
buy some wheat.
– He must wander around until he finds a farmer who is in
desperate need of a horse shoe – not exactly an easy task.
– Money disentangles the buy and sell sides.
The Role and History of Money I

• Conditions for money to be a good least-cost medium of

exchange:
1. It must be storable (imagine our money would be electricity).
2. It must have a stable purchasing power (think about the
hyperinflation in Germany in 1929).
3. It must be easy to handle (imagine our money would be bricks).
• These conditions explain the evolution of money over the
centuries: animals → metal coins → paper (fiat) money →
electronic money
The Role and History of Money II

• Animals (used in prehistoric Europe):

– Pros: None, really (... well, better than no money).
– Cons: Bulky, hard to transport and handle, need feeding
The Role and History of Money

• Metal coins (used as early as in ancient Rome):

– Pros
• Precious metals are storable, i.e., do not rust.
• Production is costly → supply can only grow slowly → inflation will
be kept low (stability is high).
• Less bulky and therefore easier to transport.
– Cons
• Metal coins can be de-based from their true value to enjoy
seignorage (de-base = reduce true precious metal content by
melting down coins, adding cheap metals and then reminting the
alloy; seignorage = profit earned from this operation).
• Risky to transport (think about good old Westerns on TV).
The Role and History of Money

• Paper (fiat) money:

– Pros: Easier and less risky to transport.
– Cons: Value of money based on trust.
The Development of the Banking
System
• The origins of privately-issued paper money:
– Traders deposit their metal coins with international banks. They
use the bank receipts (later: promissory notes = paper money) to
pay each other.
– Bank receipts can be converted into underlying coins at sight, i.e.,
when presented to the bank.
– Clever bankers quickly realized that it is unlikely that all
outstanding receipts would be converted into underlying coins at
one point in time
→ As a result, they created more bank receipts than they had
coins to cover them and thus created money.
The Development of the Banking
System
• An example of a newly-created bank (120 crowns capital) on the first
day:
– Merchant A deposits 100 crowns (→ bank vault, asset). In return, he
obtains a bank receipt from the bank (liability).
– Merchant B asks for a 200 crown loan. In exchange for a bank receipt
over 200 crowns (liability), he writes a promissory note over the same
amount to the bank (asset).
– The Government G asks for a 150 crown loan. In exchange for a 150
crown bank receipt (liability), it writes a promissory note to the bank
(asset).
• In addition,
– Foreign trader F asks for a 70 crown loan. In exchange for a 70 crown
bank receipt (liability), he writes a promissory note to the bank (asset).
– Local exporter X converts foreign notes into local notes, worth 100
crowns (liability). The bank uses the foreign notes to buy T-bills (asset).
The Development of the Banking
System
• Fiat money bears the risk of bank runs. Here’s a recipe for disaster:
– B goes to casino C and loses the 200 crown receipt. G gives the 150
crown receipt to construction company D to build a park.
– On the liabilities side: the bank has still issued receipts over a
total of 620 crowns, some of them are now in different hands.
– A, C, D panic: They want to convert their bank receipts into coins
as quickly as somehow possible → Bank run.
• To minimize the risk of bank runs, most governments have
monopolized the right to issue money through a central bank.
• Commercial banks, in fact, act as liaisons between the public and the
central bank
The Development of the Banking
System
• Monetary base M0 = D + G + RFX
– With D = credit to domestic private sector, G = credit to the
government, RFX = reserves of foreign exchange (including gold)
• Money supply M1 = m x M0 = m x (D + G + RFX)
• Central banks influence M0 or M1 through RFX (intervention in
FX markets), D or G (open-market policy), m (reserve
requirements) or credit controls.
• Central banks use several different methods to increase (or
decrease) the amount of money in the banking system.
• While the Fed could print paper currency at its discretion in an
effort to increase the amount of money in the economy, this is
not the measure used. Here are three methods the Fed uses in
order to inject (or withdraw) money from the economy:
Injecting money in the economy

• The Fed can influence money supply by modifying reserve

requirement, which is the amount of funds banks must hold against
deposits in bank accounts.
• The Fed can also alter the money supply by changing short-term
interest rates. Lowering (or raising) the discount rate that banks pay
on short-term loans from the Fed increases (or decreases) the
liquidity of money. Lower rates increase the money supply and boost
economic activity; however, it creates risk of inflation.
• Open market operations, which affect the federal fund rates (i.e.
lending rates for commercial banks). In open operations, the Fed
buys and sells government securities. If the Fed wants to increase
the money supply, it buys government bonds. Conversely, if the Fed
wants to decrease the money supply, it sells bonds from its account,
thus taking in cash and removing money from the economic system.
Balance of Payments (BOP)

• A record of all transactions between residents of one country

and the rest of the world over a specified time-period, often a
year.
• Transactions grouped into source and use tables.
• Source = ‘+’ sign: Where did the money come from (earned,
sold an asset, depleted bank account)?
• Use = ‘−’ sign: What was the money used for (bought goods or
services, paid workers, put money into bank account)?
• Rule: Every “source” must be “used” somewhere (every 5m
spent must come from somewhere), similar to double-entry
book-keeping.
BOP: Subcategories
BOP: Some Examples of Typical
Transactions

Error in
book!
BOP: Technical Details

• Accruals vs. cash accounting

• cost, insurance, freight (imports) vs. free on board (exports)
– Imports include a service charge, exports do not.
– Renders the merchandise balance (export−import of goods) less
meaningful.
• FDI vs. portfolio investment
– Underlying question: Has a controlling share been acquired in the
company?
– Impossible to determine for the central bank → cut-off rule, often 10%.
• Foreigners vs. non-residents?
• Statistical discrepancy: errors and omissions
– In a perfect world: CA + KFA = 0, i.e. if you spend more than you have
earned, you must have borrowed or sold assets.
– In practice, impossible to observe all transactions (cash payments, small
transactions, illegal transactions) → Include error term:
CA + KFA + E&O = 0
Analyzing the Current Account
(Surplus or Deficit)
• Balance of trade (e.g. goods and services) and net income.
• Availability of goods and their destination:
Y + M = Cp + Cg + Ip + Ig + X
production imports consumption investment exports
• Value of produced or imported goods = Value of consumed or invested
goods (by ‘private’ or ‘government’) plus value of exports.
• Income from goods and its uses:
Y = Cp + Sp + Tr + Tx
income consumption savings transfers taxes
• Value of private income = Value of consumed or saved income plus transfers
to foreigners (wages, dividends, etc.) plus taxes paid.
• Combining: CA = (Sp − Ip )+ (Tx− Cg − Ig )
= (Y − Cp −Tr −Tx − Ip )+ (Tx− Cg − Ig )= X − M −Tr
private surplus G’s surplus
Exchange Rates – Definition and
Principles
• Price of one currency in terms of another; convention: HC/FC (read: home
currency required to buy one unit of foreign currency).
• Similar to other prices, if FC is interpreted as just another commodity.
– 0.5 GBP/apple, 15 GBP/Latest Harry Potter book, 0.67 GBP/EUR.
– Consistent with commodity prices, the FC will always be in the denominator
(i.e. we do not write: 2 apples/GBP, so we also will not write: 1.5 EUR/GBP).
• The price of FC (the exchange rate) is governed by the forces of supply and
demand.
– An increase (decrease) in demand for the FC will increase (decrease) the
price of the FC.
– An increase (decrease) in supply of the FC will decrease (increase) the price
of the FC.
• Governments intervene in foreign exchange markets by buying and selling
currency to influence the value of the HC or the FC.
• The set of rules according to which governments intervene is called the
‘exchange rate regime’ of a country.
A Short History of Exchange Rate
Regimes I
• Before World War I: Most countries had an official gold parity (i.e.
money could be freely converted into gold at a fixed exchange rate).
– Pros: As gold is costly to produce, the money supply can only grow
slowly → low inflation → economic stability.
– Cons: Low money supply limits number of economic transactions →
hampers economic growth, but if money supply is increased faster than
gold supply, this could trigger credibility problems → bank runs (Triffin
dilemma).
• When the U.S. increased money supply above gold supply, mostly to
finance the Vietnam war and the Great Society Program, investors
took advantage of this and the system collapsed.
– expansionary policy → CA deficit → monetizing the deficit → (USD
supply/Gold supply) ↑ → real value of gold ↑ → investors buy gold at
bargain price (fixed exchange rate)
A Short History of Exchange Rate
Regimes II
• After World War II: Most countries followed a fixed exchange rate
regime, meaning they tried to keep the value of their currency fixed
with respect to another currency.
• Done through central bank intervention (buying and selling of
currency).
– Pros: Economic stability.
– Cons: Requires policy coordination = similar inflation rates (i). Example:
Assume DEM fixed to GBP; iUK=100% and iGER=0%
→ British products become more and more expensive; British
competitiveness declines. UK central bank must perpetually buy GBP,
but will sooner or later run out of reserves.
• Also possible to fix the exchange rate relative to a basket.
– Example: Assume that 60% of Freedonia’s trade is with Euroland and
40% with the United States; current exchange rates are: FDK/EUR 3 and
FDK/USD 2.5
– Now find ƞE such that:
Summary, Homework and
Additional Reading
• This week, we dealt with:
– Money: Reason for existence, necessary conditions for successful
money.
– Banking: Evolution of banking system.
– International payments: BOP, reasons for CA deficits.
– Exchange rate regimes: Gold standard, fixed exchange rate, multilaterally
fixed exchange rate; central bank intervention.
• At home, you will need to cover:
– Development of the European Monetary Union (EMU).
• Additional reading:
– Wolf, M. (2010), “Could the world go back to the gold standard?”,
Financial Times Blog, 1 November 2010.
– The Economist (2011), “Currency interventions: Francs for nothing”, The
Economist, 10 September 2011.