This summary on International Finance (Eun), part 3 is written in 2013-2014.

Chapter 1: International Finance

Three major dimensions set international finance apart from domestic finance:

1. Foreign exchange and political risks;

2. Market imperfections

3. Expanded opportunity set

The first relates to the fact when firms and individuals are engaged in cross-border transactions, they are potentially exposed to foreign exchange risk that they would not normally encounter in purely domestic transactions. The exchange rates among major currencies (US dollar, Japanese yen, British Pound, and Euro) fluctuate continuously in an unpredictable manner. This has been the case since the early 1970s, when fixed exchange rates were abandoned. Exchange rate uncertainty will have a persuasive influence on all the major economic functions, including consumption, production, and investment. The other risk, political risk, ranges from unexpected changes in tax rules to outright expropriation of assets held by foreigners. Political risk arises form the fact that a sovereign country can change the rules of the game and the affected parties may not have effective recourse. Multinational firms and investors should be particularly aware of political risk when they invest in those countries without a tradition of the rule of law.

The second dimension implies that world markets are highly imperfect. Market imperfections – various frictions and impediments preventing markets from functioning perfectly – play an important role in motivating multinational corporations (MNCs) to locate production overseas. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolios.

The third dimension is that firms can benefit from the expanded opportunity set. Firms can fain from greater economies of scale when their tangible and intangible assets are deployed on a global basis. Individual investors can also benefit greatly if they invest internationally rather than domestically. If you diversify internationally, the resulting international portfolio may have a lower risk or a higher return – or both – than a purely domestic portfolio. This can happen mainly because stock returns tend to covary less across countries than within a given country.

The book of Eun et al. is written from the perspective that the fundamental goal of sound financial management is shareholder wealth maximization. Shareholder wealth maximization means that the firms makes all business decisions and investments with an eye toward making the owners of the firm – the shareholders – better off financially, or more wealthy, than they were before. If the firm seeks to maximize shareholder wealth, it will most likely simultaneously be accomplishing other legitimate goals that are perceived as worthwhile: shareholder wealth maximization is a long-run goal.

The corporate governance is the financial and legal framework for regulating the relationship between a company’s management and its shareholders. It varies greatly across countries, reflecting different cultural, legal, economic, and political environments in different countries.

Shareholders are the owners of the business; it is their capital that is at risk. It is only equitable that they receive a fair return on their investment. Private capital may not have been forthcoming for the business firm if it had intended to accomplish any other objective. It is thus vitally important to strengthen corporate governance so that shareholders receive fair returns on their investment.

Financial managers of MNCs should learn how to manage foreign exchange and political risks using proper tools and instruments, deal with (and take advantage of) market imperfections, and benefit from the expanded investment and financing opportunities. By doing so, financial managers can contribute to shareholder wealth maximization, which is the ultimate goal of international financial management.

Several key trends and developments happened in the world economy in the last few decades:

1. The emergence of globalized financial markets

2. The emergence of the euro as a global currency

3. Europe’s sovereign debt crisis of 2010

4. The continued trade liberalization and economic integration

5. The large-scale privatization of state-owned enterprises

6. The global financial crisis of 2008-09

The advent of the euro at the start of 1999 represents a momentous event in the history of the world financial system that has profound ramifications for the world economy. Once a country adopts a common currency, it obviously cannot have its own monetary policy. The common monetary policy for the euro zone is now formulated by the European Central Bank (ECB) that is located in Frankfurt and closely modelled after the Bundesbank, the German central bank. The ECB is legally mandated to achieve price stability for the Euro zone.

The subprime mortgage crisis in the US that began in the summer of 2007 led to a severe credit crunch. The credit crunch, in turn, escalated to a major global financial crisis in 2008-09.

The global financial crisis may be attributable to several factors, including

1. Excessive borrowing and risk taking both by households and banks;

2. Failure of government regulators to detect the rising risk in the financial system and take timely preventive actions

3. The interconnected and integrated nature of financial markets

In addition, the world economy was buffeted by Europe’s sovereign debt crisis.

The sovereign debt crisis in Greece, which accounts for only about 2.5 percent of Eurozone GDP, quickly escalated to a Europe-wide debt crisis, threatening the nascent recovery of the world economy from the severe global financial crisis of 2008-09. Facing the spreading crisis, the European Union (EU) countries jointly with the International Monetary Fund (IFM) put together a massive €750 billion package to bail out Greece and other weak economies. The panic spread among weak European economies. The interest rates in these countries rose sharply, and, at the same time, the euro depreciated sharply in currency markets, hurting its credibility as a major global currency.

Thus, the Eurozone countries have achieved monetary integration by adopting the euro, but without fiscal integration. While the Eurozone countries share the common monetary policy, fiscal policies governing taxation, spending, and borrowing firmly remain under the control of national governments. Hence, a lack of fiscal discipline in a Eurozone county can always become a Europe-wide crisis, threatening the value and credibility of the common currency.

The principal argument for international trade is based on the theory of comparative advantage, which was advanced by David Ricardo in his book Principles of Political Economy (1817). It is mutually beneficial for countries if they specialize in the production of those goods they can produce most efficiently and trade those goods among them. Ricardo’s theory has a clear implication for policy: liberalization of international trade will enhance the welfare of the world’s citizens. International trade is not a zero-sum game in which one country benefits ay the expense of another country – the view held by the mercantilists. International trade could be an increasing-sum game at which all players become winners.

At the global level, the General Agreement on Tariffs and Trade (GATT, 1947) – a multilateral agreement among member countries – has played a key role in dismantling barriers to international trade.

Under the auspices of GATT, the Uruguay Round launched in 1986 aims to

1. Reduce import tariffs worldwide by an average of 38 percent;

2. Increase the proportion of duty-free products from 20 percent to 44 percent for industrialized countries;

3. Extend the rules of world trade to cover agriculture, services such as banking and insurance, and intellectual property rights.

It also created a permanent World Trade Organization (WTO) to replace GATT. The WTO has more power to enforce the rules of international trade.

On the regional level, formal arrangements among countries have been instituted to promote economic integration. The European Union (EU) is a prime example. Whereas the economic and monetary union planned by the EU is one of the most advanced forms of economic integration, a free trade area is the most basic, e.g. the North American Free Trade Agreement (NAFTA).

Through privatization, a country divests itself of the ownership and operation of business venture by turning it over to the free market system. It can be viewed in many ways. In one sense it is a denationalization process: when a national government divests itself of a state-run business, it gives up part of its national identity. Also, privatization is often seen as a cure for bureaucratic inefficiency and waste; some economists estimate that privatization improves efficiency and reduces operating costs by as much as 20 percent. One benefit of privatization for many less-developed countries is that the sale of state-owned businesses brings to the national treasury hard-currency foreign reserves. The sale proceeds are often used to pay down sovereign debt that has weighed heavily on the economy.

In addition to international trade, foreign direct investment by MNCs is a major force driving globalization of the world economy. A multinational corporation (MNC) is a business firm incorporated in one country that has production and sales operations in several other countries. MNCs obtain financing from major money centres around he world in many different currencies to finance their operations. Global operations force the treasurer’s office to establish international banking relationships, place short-term funds in several currency denominations, and effectively manage foreign exchange risk.

MNCs may gain from their global presence in a variety of ways.

• First of all, MNCs can benefit fro the economy of scale by

1. Spreading R&D expenditures and advertising costs over their global sales

2. Pooling global purchasing power over suppliers

3. Utilizing their technological and managerial know-how globally with minimum additional costs, and so forth.

• MNCs can use their global presence to take advantage of under-priced labour services available in certain developing countries, and gain access to special R&D capabilities residing in advanced foreign countries. MNCs can leverage their global presence to boost their profit margins and create shareholder value.

Chapter 2: international monetary system

The international monetary system can be defined as the institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. It is a complex set of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and capital flows. The system describes the overall financial environment in which multinational corporations and international investors operate. The international monetary system has evolved over time and will continue to do so in the future as the fundamental business and political conditions underlying the world economy will continue to shift.

The international monetary system went through several distinct stages of evolution. These are the following:

1. Bimetallism: before 1875.

2. Classical gold standard: 1875-1914.

3. Interwar period: 1915-1944.

4. Bretton Woods system: 1945-1972.

5. Flexible exchange rate regime: since 1973.

Bimetallism. Bimetallism is a double standard in that free coinage was maintained for both gold and solver. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined either by their gold or silver contents. Countries that were on the bimetallic standard often experienced the well-known phenomenon referred to as Gresham’s law. Since the exchange ratio between the two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation. This is the Gresham’s law, according to which bad (abundant) money drives out good (scarce) money.

Classic gold standard. The first full-fledged gold standard was not established until 1821 in Great Britain, when notes from the Bank of England were made fully redeemable for gold. One can say roughly that the international gold standard existed as a historical reality during 1875-1914.

An international gold standard can be said to exist when, in most major countries

1. Gold alone is assured of unrestricted coinage

2. There is two-way convertibility between gold and national currencies at a stable ratio

3. Gold may be freely imported and exported.

In order to support unrestricted convertibility into gold, bank notes need to be backed by a gold reserve of a minimum stated ration. In addition, the domestic money stock should rise and fall as gold flows in and out of the country. Under the gold standard, the exchange rate between any two currencies will be determined y their gold content. Under the gold standard, misalignment of the exchange rate will be automatically corrected by cross-border flows of gold. Also, international imbalances of payment will be corrected automatically.

Under the gold standard, the price-specie-flow mechanism (attributed to David Hume) automatically corrects payment imbalances between countries. This is based on the fact that the domestic money stock rises (falls) as the country experiences inflows (outflows) of gold.

Despite its demise a long time ago, the standard still has ardent supporters in academic, business, and political circles, which view it as the ultimate hedge against price inflation. Gold has a natural scarcity and no one can increase its quantity at will. Therefore, if gold serves as the sole base for domestic money creation, the money supply cannot get out of control and cause inflation. In addition, if gold is used as the sole international means of payments, then countries’ balance of payments will be regulated automatically via the movement of gold. As a result, no country may have a persistent trade deficit or surplus.

The gold standard also has a few key shortcomings:

1. The supply of newly minted gold is so restricted that the growth of world trade and investment can be seriously hampered for the lack of sufficient money reserves. The world economy can face deflationary pressures.

2. Whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it can abandon the gold standard. The international gold standard per se has no mechanism to compel each major country to abide the rules of the game.

It is not very likely that the classical gold standard will be restored in the foreseeable future.

Interwar period. After the war, many countries, especially Germany, Austria, Hungary, Poland, and Russia, suffered hyperinflation. By the end of 1923, the wholesale price index in Germany was more than 1 trillion times as high as the pre-war level. Freed from wartime pegging, exchange rates among currencies were fluctuation in the early 1920s. During this period, countries widely used predatory depreciations of their currencies as a means of gaining advantages in the world export market. As major countries began to recover from the war and stabilize their economies, they attempted to restore the gold standard, which turned out to be a façade. Most major countries gave priority to the stabilization of domestic economies and systematically followed a policy of sterilization of gold by matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. Countries lacked the political will to abide by the rules of the game and so the automatic adjustment mechanism of the gold standard was unable to work.

The interwar period was characterized by economic nationalism, half-hearted attempts and failure to restore the gold standard, economic and political instabilities, bank failures, and panicky flights of capital across borders. No coherent international monetary system prevailed during this period, with profoundly detrimental effects on international trade and investment. It is during this period that the US dollar emerged as the dominant world currency, gradually replacing the British pound for the role.

Bretton Woods system. The Bretton Woods system is an international monetary system created in 1944 to promote post-war exchange rate stability and coordinate international monetary policies. Otherwise known as the gold-exchange system. Under the system, each country established a par value in relation to the US dollar, which was pegged to gold at $35 per ounce (exhibit 2.1). Each country was responsible for maintaining its exchange rate within ± 1 percent of the adopted par value by buying or selling foreign exchanges as necessary. Under the system. The US dollar was the only currency that was fully convertible to gold; other currencies were not directly convertible to gold.

Under the gold-exchange system, the reserve-currency country should run balance-of-payments deficits to supply reserves, but if such deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, causing downfall of the system. This dilemma, known as the Triffin paradox, was indeed responsible for the eventual collapse of the dollar-based gold exchange system in the early 1970s.

By the early 1960s the total value of US gold stock, when valued at $35 per ounce, fell short of foreign dollar holdings. This naturally created a concern about the viability of the dollar-based system.

Efforts to remedy the problem centred on

• A series of dollar defence measures taken by the US government;

• The creation of a new reserve asset, special drawing rights (SDRs) by the IFM.

Initially the SDR was designed to be the weighted average of 16 currencies of those countries whose shares in the world exports were more than 1 percent. The percentage share of each currency in the SDR was about the same as the country’s share in world exports. Later this was cut down to only 5 major currencies. The SDR is not only used as a reserve asset, but also as a denomination currency for international transactions. Since the SDR is a portfolio of currencies, it value tends to be more stable that the value of any individual currency included in the SDR.

In an attempt to save the Bretton Woods system, 10 major countries, known as the Group of Ten, reached the Smithsonian Agreement, according to which

1. The price of gold was raised to $38 per ounce;

2. Each of the other countries revalued its currency against the US dollar by up to 10 percent;

3. The band within the exchange rates were allowed to move was expanded from 1 percent to 2.25 percent in either direction.

After a year, the agreement can under attack again. By 1973 (March), European and Japanese currencies were allowed to float completing the decline and fall of the Bretton Woods system. Since then, the exchange rates among such major currencies as the dollar, the mark (later succeeded by the euro), the pound, and the yen have been fluctuating against each other.

The flexible exchange rate regime. The key elements of the Jamaica Agreement include:

1. Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange market to iron out unwarranted volatilities.

2. Gold was officially abandoned (i.e. demonetized) as an international reserve asset. Half of the IFM’s gold holdings were returned to the members and the other half was sold, with the proceeds to be used to help poor nations.

3. Non-oil-exporting countries and less-developed countries were given greater access to IFM funds.

Following the presidential election of 1980, the Reagan administration ushered in a period of growing US budget deficits and balance-of-payments deficits. During the first half of the 1980s, the US dollar experienced a major appreciation because of the large-scale inflows of foreign capital caused by unusually high real interest rates available in the US. To attract foreign investment to help finance the budget deficit, the US had to offer high real interest rates. The heavy demand for dollars by foreign investors pushed up the value of the dollar in the exchange market.

In the Plaza Accord (1985) the G-5 agreed that depreciation of the US dollar is desirable to correct the US trade deficits. They expressed the willingness to intervene in the exchange market to realize this object. After that there was the Louvre Accord (1987): an agreement, prompted by the dollar’s decline, in which the G-7 countries

1. Cooperate to achieve greater exchange rate stability

2. Consult and coordinate their macroeconomic policies.

The Louvre Accord marked the inception of the managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct over- or undervaluation of currencies. Following the accord, exchange rates became relatively more stable for a while.

During the period 1996-2001, the US dollar generally appreciated, reflecting a robust performance of the US economy fuelled by the technology boom. In 2001, the dollar began to depreciate due to a sharp stock market correction, the ballooning trade deficits, and the increased political uncertainty following the September 11 attacks.

Current exchange rate arrangements. The IFM currently classifies exchange rate agreements into 10 separate regimes (exhibit 2.4):

• No separate legal tender: the currency of another country circulates as the sole legal tender. Adopting such an arrangement implies complete surrender of the monetary authorities’ control over the domestic monetary policy.

• Currency board: a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfilment of its legal obligation. This implies that domestic currency is usually fully backed by foreign assets, elimination traditional central bank function such as monetary control and lender of last resort, and leaving little room for discretionary monetary policy.

• Conventional peg: the country formally pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed, e.g. from the currencies of major trading or financial partners and weights reflect the geographic distribution of trade, services, or capital flows. There is no commitment to irrevocably keep the parity, but the formal arrangements must be confirmed empirically: the exchange rate may fluctuate within narrow margins of less than ±1 percent around a central rate.

• Stabilized arrangement: classification as a stabilized arrangement entails a spot market exchange rate that remains within a margin of 2 percent for six months or more.

• Crawling peg: involves the confirmation of the country authorities’ de jure exchange rate arrangement. The currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners.

• Crawl-like arrangement: the exchange rate must remain within a narrow margin of 2 percent relative to a statistically identified trend for sic months or more, and the exchange rate arrangement cannot be considered as floating. Usually, a minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is required.

• Pegged exchange rate within horizontal bands: the value of the currency is maintained within certain margins of fluctuations of at least ±1 percent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent.

• Other managed arrangement: this category is residual, and is used when the exchange rate arrangement does not meet the criteria of any of the other categories.

• Floating: a floating exchange rate is largely market determined, without an ascertainable or predictable path for the rate. Foreign exchange market intervention may be either direct or indirect, and serves to moderate the rate of change and prevent undue fluctuations in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible with floating.

• Free floating: a floating exchange rate can be classified as free floating if intervention occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or date confirming that intervention has been limited to at most three instances in the previous six months, each lasting no more than three business days.

European Monetary System. In 1971, members of the European Economic Community (EEC) decided on a narrower band of ±1.125 percent for their currencies. This scaled-down, European version of the fixed exchange rate system that arose concurrently with the decline of the Bretton Woods system was called the snake – derived from the way the EEC currencies moved closely together within the wider band allowed for other currencies like the US dollar. The snake arrangement was replaced by the European Monetary System (EMS) in 1979. It chief objectives were

1. To establish a zone of monetary stability in Europe;

2. To coordinate exchange rate policies vis-à-vis the non-EMS currencies;

3. To pave the way for the eventual European monetary union.

The European currency unit (ECU) is a basket currency constructed as a weighted average of the currencies of member countries of the European Union (EU). The weights are based on the each currency’s relative GNP and share in intra-EU trade. The ECU serves as the accounting unit of the EMS and plays an important role in the workings of the exchange rate mechanism.

The Exchange Rate Mechanism (ERM) refers to the procedure by which EMS member countries collectively manage their exchange rates.

Despite the recurrent turbulence in the EMS, European Union members met at Maastricht (Netherlands) in December 1991 and signed the Maastricht Treaty – stating that the EU will irrevocably fix exchange rates among member countries by January 1999 and introduce a common European currency, which will replace individual national currencies.

The euro and the European Monetary Union. The euro should be viewed as a product of historical evolution toward an ever deepening integration of Europe, which began in earnest with the formation of the European Economic Community in 1958. With the launching of the euro on January 1, 1999, the European Monetary Union (EMU) was created. As the euro was introduced, each national currency of the euro-11 countries was irrevocably fixed to the euro at a conversion rate as of January 1, 1999 (exhibit 2.6).

Monetary policy for the euro zone countries is now conducted by the European Central Bank (ECB), headquartered in Frankfurt (Germany), whose primary objective is to maintain price stability. The ECB is modelled after the Bundesbank, which was highly successful in achieving price stability in Germany. Willem (Wim) Duisenberg, the first president of the ECB, previously served as the present of the Nederlandsche Bank, defined price stability as an annual inflation rate of less than but close to 2 percent. The national central banks of the euro zone countries, together with the ECB, for the Eurosystem, which is in a way similar to the Federal Reserve System of the United States.

The tasks of the Eurosystem are threefold:

1. To define and implement the common monetary policy of the union;

2. To conduct foreign exchange operations;

3. To hold and manage the official foreign reserves of the euro member states.

What are the main benefits from adopting a common currency?

• Reduced transaction costs;

• Elimination of exchange rate uncertainty;

• More depth and liquidity;

• More political corporation and peace.

What are the costs of adopting a common currency?

• Loss of national monetary independence;

• Loss of exchange rate policy independence.

The Mexican Peso Crisis. On December 20, 1994 the Mexican government decided to devaluate the peso against the US dollar by 14 percent. However, this touched off a stampede to sell pesos as well as Mexican stocks and bonds. A bailout plan was put together and announced on January 31, leading to the stabilization of the world’s, as well as Mexico’s, financial markets (exhibit 2.9).

As the world’s financial markets are becoming more integrated, this type of contagious financial crisis is likely to occur more often.

Two lessons emerge from this peso crisis:

1. It is essential to have a multinational safety net in place to safeguard the world financial system from the peso-type crisis. No single country or institution can handle a potentially global crisis alone.

2. Mexico excessively depended on foreign portfolio capital to finance its economic development. In hindsight, the country should have saved more domestically and depended more on long-term rather than short-term foreign capital investments.

Asian currency crisis. On July 2, 1997, the Thai Baht, which had been largely fixed to the US dollar, was suddenly devaluated (exhibit 2.10). The Asian crises turned out to be far more serious than those of its predecessors of the 1990s (the EMS crisis in 1992; the Mexico peso crisis in 1994-95) in terms of the extent of contagion and the severity of resultant economic and social costs.

The crisis led to an unprecedentedly deep, widespread, and long-lasting recession in East Asia, a region that, for the last few decades has enjoyed the most rapidly growing economy in the world. Simultaneously, many lenders and investors from the developed countries also suffered large capital losses from their investments in emerging-market securities.

Given the global effects of the Asian currency crisis and the challenges it poses for the world financial system, it would be useful to understand its origins and causes and discuss how similar crisis might be prevented in the future.

In general, liberalization of financial markets when combined with weak, underdeveloped domestic financial system tends to create an environment susceptible to currency and financial crisis. It seems safe to recommend that countries first strengthen their domestic financial system and then liberalize their financial markets.

A number of measures can/should be undertaken to strengthen a nation’s domestic financial system

• Government should strengthen its system of financial-sector regulation and supervision.

• Banks should be encouraged to base their lending decisions solely on economic merits rather than political considerations

• Firms, financial institutions, and the government should be required to provide the public with reliable financial data in timely fashion. This will make it easier for all the concerned parties to monitor the situation better and mitigate the destabilizing cycles of investor euphoria and panic accentuated by the lack of reliable information.

Even if a country decides to liberalize its financial markets by allowing cross-border capital flows, it should encourage foreign direct investments and equity and long-term bond investments; it should not encourage short-term investment that can be reversed overnight, causing financial turmoil. As Chile has successfully implemented, some form of Tobin tax on the international flow of hot money can be useful.

A fixed but adjustable exchange rate is problematic in the face of integrated international financial markets. Such rates often invite speculative attack at the time of financial vulnerability. Countries should not try to restore the same fixed exchange rate system unless they are willing to impose capital controls.

A country can attain only two of the following three conditions (incompatible trinity):

1. A fixed exchange rate;

2. Free international flows of capital;

3. Independent monetary policy.

Argentine Peso Crisis. The 2002 crisis of the Argentine Peso shows that even a currency board arrangement cannot be completely safe from a possible collapse (exhibit 2.13). The strong peso did hurt exports from Argentina and caused a protracted economic downturn that eventually led to the abandonment of the peso-dollar parity in January 2002. This change caused severe economic and political distress in the country (higher unemployment; hyperinflation).

There were at least three factors that were related to the collapse of the currency board system and ensuring economic crisis:

1. The lack of fiscal discipline;

2. Labour market inflexibility;

3. Contagion from the financial crisis in Russia and Brazil

Fixed versus flexible exchange rate regimes. The key arguments for flexible exchange rates rest on:

1. Easier external adjustments

2. National policy autonomy.

Its possible drawback is:

1. That exchange rate uncertainty may hamper international trade and investment

An ideal international monetary system should provide:

2. Liquidity;

3. Adjustment;

4. Confidence.

Thus, a good IMS should be able to

1. Provide the world economy with sufficient monetary reserves to support the growth of international trade and investment.

2. It should also provide an effective mechanism that restores the balance-of-payments equilibrium whenever it is disturbed.

3. It should offer a safeguard to prevent crises of confidence in the system that result in panicked flights from one reserve asset to another.

Politicians and economists should keep these three criteria in mind when they design and evaluate the international monetary system.

Chapter 3: BOP – Balance of Payments

The balance of payments (BOP) refers to a statistical record of a country’s transactions with the rest of the world over a certain period of time. The definition is: The statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping.

1. It provides detailed information concerning the demand and supply of a country’s currency.

2. It may also signal its potential as a business partner for the rest of the world.

3. It can also be used to evaluate the performance of the country in international economic competition.

Since the BOP is recorded over a certain period of time (i.e. a quarter or a year), it has the same time dimension as national income accounting. Since it is represented as a system of double-entry bookkeeping, every credit in the account is balanced by a matching debit, and vice versa. Not only international trade (imports & exports), but also cross-border investments are recorded in the BOP.

The main balance-of-payments accounts. A country’s international transactions can be grouped into the following three main types:

1. Current account – the exports & imports of goods and services;

2. Capital account – all purchases and sales of assets, such as stocks, bonds, bank accounts, real estate, and businesses;

3. Official reserve account – all purchases and sales of international reserve assets, such as US dollar, other foreign exchanges (such as euro and pound, gold, and SDRs)

The current account is divided into four finer categories:

1. Merchandise trade: export/import of tangible goods (oil, clothes).

2. Services: payments/receipts for legal, consulting, and engineering services, royalties for patents and intellectual properties, insurance premiums, shipping fees, and tourist expenditures – sometimes called invisible trade.

3. Factor income: payments/receipts of interest, dividends and other income on foreign investments that were previously made.

4. Unilateral transfers: unrequited payments – e.g. foreign aid, reparations, official/private grants, and gifts. These only have one-directional flows, without offsetting flows.

The current account balance tends to be sensitive to exchange rate changes. The effect of currency depreciation on a country’s trade balance can be quite complication. Following depreciation, the trade balance may at first deteriorate for a while. Eventually, however, the trade balance will tend to improve over time. This particular reaction pattern of the trade balance to depreciation is referred to as the J-curve effect (exhibit 3.2). a depreciation will begin to improve the trade balance immediately if imports and exports are responsive to the exchange rate changes. On the other hand, if imports and exports are inelastic, the trade balance will worsen following a depreciation.

On the capital account, sales (exports) of assets are recorded as credits, as they result in capital inflow. On the contrary, purchases (imports) of foreign assets are recorded as debits, as they lead to capital outflow. Unlike trades in goods and services trades in financial assets affect future payments and receipts of factor income.

The capital account can be divided into three categories:

1. Foreign direct investment (FDI): investment in a foreign country that gives a multinational company a measure of control.

2. Portfolio investment: represents sales/purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of control.

3. Other investment: transactions in currency, bank deposits, trade credits, and so forth. These investments are quite sensitive to both changes in relative interest rates between countries and the anticipated change in the exchange rate.

When we compute the cumulative balance of payments including the current account, capital account, and the statistical discrepancies, we obtain the overall balance, or official settlement balance. All the transactions comprising the overall balance take place autonomously for their own sake. The overall balance is indicative of a country’s BOP gap that that must be accommodated by official reserve transactions.

If a country must make a net payment to foreigners because of a balance-of-payments deficit, the country should either run down its official reserve assets, such as gold, foreign exchanges, and SDRs, or borrow anew from foreigners. When the country has a BOP surplus, its central bank will either retire some of its foreign debts or acquire additional reserve assets from foreigners. The official reserve account includes transactions undertaken by the authorities to finance the overall balance and intervene in foreign exchange markets.

Until the advent of the Bretton Woods system in 1945, gold was the predominant international reserve asset. After 1945, international reserve assets comprise:

1. Gold;

2. Foreign exchanges;

3. Special drawing rights (SDRs);

4. Reserve positions in the International Monetary Fund (IMF).

The balance of payment identity. When the BOP accounts are recorded correctly, the combined balance of the current account, the capital account, and the reserves account must be zero, that is the balance-of-payments identity (BOPI):

BCA + BKA + BRA = 0

Where

BCA + BKA is nonzero, without adjusting the exchange rate. Under the fixed exchange rate regime, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the official reserve

BCA + BKA = – BKA

Under the pure flexible exchange rate regime, central banks will not intervene in the foreign exchange markets. In fact, central banks do not need to maintain official reserves. Under this regime, the overall balance thus must necessarily balance, that is

BCA = – BKA

In other words, a current account surplus (deficit) must be matched by a capital account deficit (surplus).

Chapter 8: The international bond market

The international bond market encompasses two basic market segments

1. Foreign bonds;

2. Eurobonds.

A foreign bond issue is one offered by a foreign borrower to the investors in a national capital market and denominated in that nation’s currency. These must meet the security regulations of the country in which they are issued.

A Eurobond issue is one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. Eurobonds are usually bearer bonds – possession is evidence of ownership. The issuer does not keep any records indicating who is the current owner of a bond. With registered bonds, the owner’s name is on the bond and it is also recorded by the issuer, or else the owner’s name is assigned to a bond serial number recorded by the issuer.

US security regulations:

• Prior to 1984, the US required a 30% withholding tax on interest paid to non-residents who held US government or corporate bonds. Moreover, US firms issuing Eurodollar bonds from the US were required to withhold the tax on interest paid to foreigners. In 1984 the withholding tax law was repealed. Additionally, US corporations were allowed to issue domestic bearer bonds to non-residents, but Congress would not grand this privilege to the Treasury.

• SEC Rule 415 (instituted in 1982) allowed shelf registration. Shelf registration allows an issuer to preregister a securities issue, and then shelve the securities for later sale when financing is actually needed. It has thus eliminated the time delay in bringing a foreign bond issue to market in the US, but it has not eliminated the information disclosure that many foreign borrowers find too expensive and/or objectionable.

• SEC Rule 144A (instituted in 1990) allows qualified institutional buyers (QIBs) in the US to trade in private placement issues that do not have to meet the strict information disclosure requirements of publicly traded issues. It was designed to make the capital markets more competitive with the Eurobond market.

The first global bond was offered in 1989, its issue is a very large bond issue that would be difficult to sell in any one country or region of the world. Consequently, it is simultaneously sold and subsequently traded in major markets worldwide. The average size has been about one billion dollars, mainly denominated in US dollar. The portion of a US dollar global bond sold by a US (foreign) borrower in the US is classified as a domestic (Yankee) bond and the portion sold elsewhere is a Eurobond.

Types of instruments. The international bond market has been much more innovative than the domestic bond market in the types of instruments offered to investors.

These are the instruments available:

• Straight fixed-rate bond issues have a designated maturity date at which the principal of the bond issue is promised to be repaid. During the life of the bond, fixed coupon payments (percentage of face value) are paid as interest to the bondholders. In contrast to many domestic bonds, which make semi-annual coupon payments, coupon interest on Eurobonds is typically paid annually. The reason is that the Eurobonds are usually bearer bonds and annual coupon redemption is more convenient for the bondholders and less costly for the bond issuer because the bondholders are scattered geographically.

• Euro-medium-term notes (Euro-MTNs) are (typically) fixed-rate notes issued by a corporation with maturities ranging from less than a year to about 10 years. Like fixed-rate bonds, Euro-MTNs have a fixed maturity and pay coupon interest on periodic dates. Unlike a bond issue, in which the entire issue is brought to the market at once, a Euro-MTN issue is partially sold on a continuous basis through an issuance facility that allows the borrower to obtain funds only as needed on a flexible basis. This feature is very attractive to issuers.

• Floating-rate notes (FRNs) are typically medium-term bonds with coupon payments indexed to some reference rate. Common reference rates are either three-month or six-month US dollar LIBOR. Coupon payments are usually quarterly or semi-annual and in accord with the reference rate, e.g. at the beginning of every six month period, the next semi-annual coupon payment is reset to be 0.5*(LIBOR + x percent) of the face value, where X represents the default risk premium above LIBOR the issuer must pay based on its creditworthiness.

• Equity-related bonds are convertible bonds and bonds with equity warrants:

• • Convertible bonds issue allows the investor to exchange the bond for a predetermined number of equity shares of the issuer. The floor-value of such a bond is its straight fixed-rate bond value. These bonds usually sell at a premium above the larger of their straight debt value and their conversion value. Additionally, investors are usually willing to accept a lower coupon rate of interest than the comparable straight fixed coupon bond rate because they find the conversion feature attractive.

• • Bonds with equity warrants can be seen as straight fixed-rate bonds with the addition of a call option (or warrant) feature. The warrant entitles the bondholder to purchase a certain number of equity shares in the issuer at a pre-stated price over a predetermined period of time.

• Dual-currency bond is a straight fixed-rate bond issued in one currency, which pays coupon interest in that same currency. At maturity, the principal is repaid in another currency. Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, this bond includes a long-term forward contract.

International Bond Market Credit Ratings. Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s provide credit ratings on most international bond issues (exhibit 8.6). It has been noted that a disproportionate share of Eurobonds has high credit ratings. The evidence suggests that a logical reason for this is that the Eurobond market is accessible only to firms that have good credit ratings to begin with. An entity’s credit rating is usually never higher than the rating assigned to the sovereign government of the country in which it resides. S&P’s analysis of a sovereign includes an examination of political and economic risk (exhibit 8.7).

Eurobond market structure and practices.

• Primary market for Eurobonds: a borrower desiring to raise funds by issuing Eurobonds to the investing public will contact an investment banker and ask it to serve as the lead manager of an underwriting syndicate that will bring the bonds to the market. The underwriting syndicate is a group of investment banks, merchant banks, and the merchant banking arms of commercial banks that specialize in some phase of a public issuance. The lead manager will sometimes invite co-managers to for a managing group to help negotiate terms with the borrower, ascertain market conditions, and manage the issuance (exhibit 8.8). the managing group, along with other banks, will serve as underwriters for the issue – they will commit their own capital to buy the issue from the borrower at a discount from the issue price. The discount – underwriting spread – is typically in the 2 – 2.5 percent range. Most of the underwriters, will be part of the selling group that sells the bonds to the investing public. The various members of the underwriting syndicate receive a portion of the spread depending on the number and type of functions they perform. The lead manager receives the full spread.

• Secondary market for Eurobonds: this is the over-the-counter market with principal trading in London. Market makers stand ready to buy/sell for their own account by quoting two-way bid and ask prices. Brokers accept buy/sell orders from market makers an then attempt to find a matching party for the other side of the trade; they may also trade for their own account. Brokers charge a small commission for their services to the market maker that engaged them. They do not deal directly with retail clients.

• Clearing systems. Two major clearing systems, Euroclear, and Clearstream International, have been established to handle most Eurobond trades. Both systems operate in a similar manner. Each clearing system has a group of depository banks that physically store bond certificates. Members of either system hold cash and bond accounts. The systems also perform other functions associated with the efficient operation of the Eurobond market:

• • The clearing system will finance up to 90 percent of the inventory that a Eurobond market maker has deposited within the system.

• • The clearing system will assist in the distribution of a new bond issue. The clearing system will take physical possession of the newly printed bond certificates in the depository, collect subscription payments from the purchasers, and record ownership of the bonds.

• • The clearing system will also distribution coupon payments. The borrower pays to the system the coupon interest due on the portion of the issue held in the depository, which in turn credits the appropriate amounts to the bond owners’ cash accounts.

International bond market indexes. The investment banking firm of J.P. Morgan and Company provides some of the best international bond market indexes that are frequently used for performance evaluations.

Chapter 9: International Equity Markets

In general S&P’s Emerging Markets Data Base classifies a stock market as ‘emerging’ if it meets at least one of two general criteria:

1. It is located in a low- or middle-income economy as defined by the World Bank;

2. Its investable market capitalization is low relative to its most recent GNI figures.

Investment in foreign equity markets became common practice in the 1980s as investors became aware of the benefits of international portfolio diversification. However, during the 1980s, cross-border equity investment was largely confined to the equity markets of developed countries. Only in the 1990s did world investors start to invest sizeable amounts in the emerging equity markets, as the economic growth and prospects of the developing countries improved.

A liquid stock market is one in which investors can buy and sell stocks quickly at close to the current quoted prices. A measure of liquidity for a stock market is the turnover ratio – that is, the ratio of stock market transactions over a period of time divided by size, or market capitalization, of the stock market. Generally, the higher the turnover ratio, the more liquid the secondary stock market, indicating ease in trading.

In order to construct a diversified portfolio there must be opportunities for making foreign investment. The more concentrated a national equity market is in a few stock issues, the less opportunity a global investor has to include shares from that country in an internationally diversified portfolio. The smaller the concentration ratio percentage, the less concentrated a market is in a few stock issues. The number of equity investment opportunities in emerging stock markets in developing country has not been improving in recent years.

Market structure and trading practices. The secondary equity markets of the world serve two major purposes.

They provide

1. Marketability;

2. Share valuation

Investors or traders who buy shares from the issuing firm in the primary market may not want to hold them indefinitely. The secondary market allows shareowners to reduce their holdings of unwanted shares and purchasers to acquire stock. Firms would have a difficult time attracting buyers in the primary market without the marketability provided through the secondary market. In addition, competitive trading between buyers and sellers in the secondary market establishes fair market prices for existing issues.

In conducting a trade in a secondary market, public buyers and sellers are represented by an agent – a broker. The order submitted to the broker may be a market order or a limit order:

• Market order is executed at the best price available in the market when the order is received, that is, the market price.

• Limit order is an order away from the market price that is held in a limit order book until it can be executed at the desired price.

There are many different designs for secondary markets that allow for efficient trading of shares between buyers and sellers.

• In a dealer market, the broker tales the trade through the dealer, who participates in trades as a principal by buying and selling the security for his own account. Public traders do not trade directly with one another in a dealer market. The over-the-counter (OTC) market is a dealer market. The National Association of Security Dealers Automated Quotation System (NASDAQ) is a computer-linked system that shows the bid (buy) and ask (sell) prices of all dealers in a security.

• In an agency market, the broker takes the client’s order through the agent, who matches it with another public order. The agent can be viewed as a broker’s broker: other names for the agent are official broker and central broker.

The exchange markets in the US (the two biggest being NYSE and AMEX) are agency/auction markets. Each stock traded on the exchange is represented by a specialist who makes a market by holding an inventory of the security. Each specialist has a designated station (desk) on the exchange trading floor where trades in his stock are conducted.

Both the OTC and the exchange markets in the US are continuous markets where market and limit orders can be executed at any time during business hours.

However, not all stock market systems provide continuous trading.

• In a call market, an agent of the exchange accumulates, over a period of time, a batch of orders that are periodically executed by written or verbal auction throughout the trading dat. Both market and limit orders are handled this way. The major disadvantage of a call market is that traders are not certain about the price at which their orders will transact because bid and ask quotations are not available prior to the call.

• Crowd trading is organized as follows: in a trading ring, an agent of the exchange periodically calls out the name of the issue. At this point, traders announce their bid and ask prices for the issue and seek counterparts to a trade. Between counterparts a deal may be struck and a trade executed. Several bilateral trades may take place at different prices.

Continuous trading systems are desirable for actively traded issues, whereas call markets and crowd trading offer advantages for thinly traded issues because they mitigate the possibility of sparse order flow over short time periods.

Trading in international equities. Cross listing refers to a firm having its equity shares listed on one or more foreign exchanges, in addition to the home country stock exchange. Cross listing of a firm’s stock obligates the firm to adhere to the securities regulations of its home country as well as the regulations of the countries in which it is cross listed.

A firm may decide to cross-list its shares for many reasons:

1. Cross listing provides a means for expanding the investor base for a firm’s stock, thus potentially increasing its demand. Increased demand for a company’s stock may increase the market price. In addition, greater market demand and a broader investor base improve the price liquidity of the security.

2. Cross listing establishes name recognition of the company in a new capital market, the paving the way for the firm to source new equity or debt capital from local investors as demands dictate. This is an especially important reason for firms from emerging market countries with limited capital markets to cross list their shares on exchanges in developed countries with enhanced capital market access.

3. Cross listing brings the firm’s name before more investor and consumer groups. Local consumers (investors) may more likely become investors in (consumers of the) company’s stock (products) if the company’s stock is (products are) locally available. International portfolio diversification is facilitated for investors if they can trade the security on their own stock exchange.

4. Cross listing into developed capital markets with strict securities regulations and information disclosure requirements may be seen as a signal to investors that improved corporate governance is forthcoming.

5. Cross listing may mitigate the possibility of a hostile takeover of the firm through the broader investor base created for the firm’s shares.

According to the bonding theory, a US cross listing both restricts the ability of corporate insiders of the cross listed firm from consuming private benefits and also publicly benefits terms.

Yankee stock offerings are the direct sale of new equity capital to US public investors. Three factors appear to be fuelling the sale of Yankee stocks:

• The push for privatization by many Latin American and Easter European government-owned companies

• The rapid growth in the economies of the developing countries.

• The large demand for new capital by Mexican companies following approval of the North American Free Trade Agreement (NAFTA).

Yankee stock issues often trade on the US exchanges as American Depository Receipts (ADRs) – a receipt representing a number of foreign shares that remain on deposit with the US depository’s custodian in the issuer’s home market. The bank serves as the transfer agent for the ADRs, which are traded on the listed exchanges in the US or in the OTC market. ADRS offer the US investor many advantages over trading directly in the underlying stock on the foreign exchange. Non-US investors can also invest in ADRs , and frequently do so rather than invest in the underlying stock because of the investment advantages.

Advantages of ADRs:

1. ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased though the investor’s regular broker.

2. Dividends received on the underlying shares are collected and converted to dollars by the custodian and paid to the ADR investor, whereas investment in the underlying shares requires the investor to collect the foreign dividends and make a currency conversion.

3. ADR trades clear in three business days as so do US equities, whereas settlement practices for the underlying stock vary in foreign countries.

4. ADR price quotes are in USD.

5. ADRs are registered securities that provide for the protection of ownership rights, whereas most underlying stocks are bearer securities.

6. An ADR investment can be sold by trading the depository receipt to another investor in the US stock market, or the underlying shares can be sold in the local stock market. In this case the ADR is delivered for cancellation to the bank depository, which delivers the underlying shares to the buyer (exhibit 9.10).

7. ADRs frequently represent a multiple of the underlying shares, rather than a one-for-one correspondence, to allow the ADR to trade in a price range customary for US investors. A single ADR may represent more or less than one underlying share, depending upon the underlying share value.

8. ADR holders give instructions to the depository bank as to how to vote the rights associated with the underlying shares. Voting rights are not exercised by the depository bank in the absence of specific instructions from the ADR holders.

There are two types of ADRs:

1. Sponsored ADRs are created by a bank at the request of the foreign company that issued the underlying security. The depository fees are paid by the foreign company.

2. Unsponsored ADRs were usually created at the request of a US investment banking firm without direct involvement by the foreign issuing firm. Consequently, the foreign company may not provide investment information or financial reports to the depository on a regular basis or timely manner. ADR investors pay the depository fees on unsponsored ADRs. These may have several issuing banks, with the terms of the offering varying from bank to bank.

In general, only sponsored ADRs trade on NASDAQ or the major stock exchanges.

Several empirical studies document important findings on cross-listing in general and on ADRs in particular.

• Park (1990) found that a substantial portion of the variability in ADR returns is accounted for by variation in the share price of the underlying security in the home market. However, information observed in the US market is also an important factor in the ADR return generating process.

• Kao et al. (1991) found that an internationally diversified portfolio of ADRs outperforms both a US stock market and a world stock market benchmark on risk adjusted basis.

• Jayaraman et al. (1993) found positive abnormal performance of the underlying security on the initial listing date. They interpret this as evidence that an ADR listing provides the issuing firm with another market from which to source new equity capital. Also, they found an increase in the volatility of returns of the underlying stock.

• Gagnon & Karolyi (2004) discovered that for most stock, prices of cross-listed shares are within 20 to 85 basis points of the home market shares, thus limiting arbitrage opportunities after transaction costs. However, when institutional barriers that limit arbitrage exist, prices can deviate by as much as a 66 percent premium and an 87 percent discount.

• Berkman & Nguyen (2010) their result indicate that cross-listed firms from countries with a poor corporate governance and/or weak accounting standards gain from improvements in domestic liquidity in the first two years after cross-listing but tend to diminish later on. They found little evidence that cross-listing result in significant improvement in domestic liquidity. Their results are not in line with the bonding theory, which predicts that firms from countries with weak investor protection should experience permanent improvements in domestic liquidity.

• Abdallah & Ioannidis (2010) found that firms cross-list in a period of good performance in their local market tot take advantage of an overvaluation of share prices to raise new capital in the cross listed country. In addition, they found that abnormal returns exhibits a significant decline after cross-listing, which is more pronounced the higher the level of the pre-cross-listing return.

• Doidge et al. (2010) found that firms that delist and leave US markets do so because they do not foresee the need to raise new external funds. They did not find that the Sarban-Oxley act (SOX, 2002) is a major determinant in decisions to leave US markets.

International equity market benchmarks. As a benchmark of activity or performance of a given national equity market, an index of the stocks traded on the secondary exchange(s) of a country is used. Several national equity indexed are available for use by investors, e.g. Global Stock Markets Factbook (S&P), MSCI (MSCI Barra), Financial Times, ADR Index (S&P).

iShares MSCI. iShares MSCI are baskets of stock designed to replicate various MSCI stock indexes. Presently, there are 58 iShares MSCI, of which 31 are country-specific funds and the remaining 27 replicate other MSCI indexed, such as the World, EAFE, and Emerging Markets Index. iShares are exchange-traded funds; most trade on NYSE AMEX. iShares are a low-cost, convenient way for investors to hold diversified investments in several different countries.

Factors affecting international equity returns.

• Macroeconomic factors

• Exchange rates

• Industrial structure

Chapter 11: international portfolio investment

This chapter focuses on five issues:

1. Why investors diversify their portfolios internationally;

2. How much investors can gain from international diversification;

3. The effects of fluctuating exchange rates on international portfolio investments;

4. Whether and how much investors can benefit from investing in international mutual funds and country funds;

5. The possible reasons for home bias in actual portfolio holdings.

Portfolio risk reduction through international diversification. Investors diversify their portfolio holdings internationally for the same reason they may diversify domestically – to reduce risk as much as possible. Investors can reduce portfolio risk by holding securities that are less than perfectly correlated. In fact, the less correlated the securities in the portfolio, the lower the portfolio risk.

International diversification has a special dimension regarding portfolio risk diversification: security returns are much less correlated across countries than within a country. This is because political, institutional, economic, and even psychological factors affecting security returns tend to vary a great deal across countries, resulting in relatively low correlations among international securities. Additionally, business cycles are often asynchronous among countries, further contributing to low international correlations.

Since the magnitude of gains from international diversification in terms of risk reduction depends on international correlation structure, it is useful to examine it empirically. The results can be found in exhibit 11.1

Exhibit 11.2, adopted from the Solnik study, first shows that as the portfolio holds more and more stocks, the risk of the portfolio steadily declines, and eventually converges to the systematic (or non-diversifiable) risk – that is, the risk that remains even after investors fully diversify their portfolio holdings. When fully diversified, an international portfolio can be less than half as risky as a purely US portfolio.

Optimal international portfolio selection. Rational investors select portfolio by considering returns as well as risk. Investors may be willing to bear some extra risk if they are sufficiently compensated by a higher expected return.

Exhibit 11.3 provides the mean and the standard deviation of monthly returns and the world beta measure for each market. The world beta measures the sensitivity of a national market to world market movements. National stock markets have rather distinct risk-return characteristics. Also, exhibit 11.3 presents the historical performance measures for national stock markets, that is

where and are, respectively, the mean and the standard deviation of returns, and R_f is the risk free interest rate. This expression is known as the Sharpe performance measure (SHP). It provides a risk-adjusted performance measure. It represents the excess return (above and beyond the risk-free interest rate) per standard deviation risk. Exhibit 11.4 illustrates the choice of the optimal international portfolio (OIP). The result is presented in exhibit 11.5. Note that OIP has the highest possible Sharpe ratio (SHP).

We can also solve for the composition of the optimal international portfolio from the perspective of each of the international investors. Since the risk-return characteristics of international stock markets vary depending on the numeraire currency used to measure returns, the composition of the optimal international portfolio will also vary across national investors using different numeraire currencies. Exhibit 11.5 presents the composition of the optimal international portfolio from the currency perspective of each national investor.

The last column of exhibit 11.5 provides the composition of the optimal international portfolio in terms of the local currency (LC), constructed ignoring exchange rate changes. It is the optimal international portfolio that would have been obtained if exchange rates had not changes. As such, it can tell us the effect of currency movements on the compositions of international portfolios.

Evaluation of gains from optimal international portfolios. We can measure gains from holding international portfolios in two different ways:

1. The increase in the Sharpe performance measure;

2. The increase in the portfolio return at the domestic-equivalent risk level.

The increase in the Sharpe performance measure, ∆SHP, is given by the difference in the Sharpe ratio between the optimal international portfolio (OIP) and the domestic portfolio (DP), that is,

∆SHP = SHP(OIP) – SHP(DP)

Here ∆SHP represents the extra return per standard deviation risk accruing from international investment. On the other hand, the increase in the portfolio return at the domestic-equivalent risk level is measured by the difference in return between the domestic portfolio (DP) and the international portfolio (IP) that has the same risk as the domestic portfolio. This additional return, ∆R, accruing from international investment at the domestic-equivalent risk level, can be computed by multiplying ∆SHP by the standard deviation of the domestic portfolio, that is,

∆R = (∆SHP) ()

Exhibit 11.6 presents both measures of the gains from international investment from the perspective of each national investor. The gains from international portfolio diversification (IDP) are much larger form some national investors. Each of these national investors can increase the Sharpe ration by more than 70 percent. The data in exhibit 11.6 suggest that, regardless of domicile and numeraire currency, investors can potentially benefit from IPD to a varying degree.

The effects of changes in the exchange rate. The realized dollar returns for a US resident investing in a foreign market will depend not only on the return in the foreign market, but also on the change in the exchange rate between the dollar and the local (foreign) currency. Therefore, the success of foreign investment rests on the performances of both the foreign security market and the foreign currency.

Formally, the rate of return in dollar terms from investing in the ith foreign market, R_i$, is given by

R_i$ = (1 + R_i) (1 + e_i) – 1

R_i$ = R_i + e_i +R_ie_i

Where R_i is the local currency rate of return from the ith foreign market and e_i is the rate of change in the exchange rate between the local currency and the dollar. e_i will be positive (negative) if the foreign currency appreciates (depreciates) against the dollar.

The last two equations suggest that for a US (or US dollar-based) investor, exchange rate changes affect the risk of foreign investment as

Var (R_i$) = Var (R_i) + Var (e_i) + 2Cov (R_i, e_i) + ∆Var

Where the ∆Var term represents the contribution of the cross-product term, R_ie_i, to the risk of foreign investment. Should the exchange rate be certain, only one term, Var(R_i) would remain in the right-hand side of the equation.

The equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three possible channels

1. Its own volatility: Var (e_i)

2. Its covariance with the local market returns: 2Cov (R_i, e_i)

3. The contribution of the cross product term: ∆Var

Exchange rate volatility is much greater than bond market volatility. And exchange rate changes may co-vary positively or negatively with local bond market returns. Empirical evidence regarding bond market suggests that it is essential to control exchange risk to enhance the efficiency of international bond portfolios.

Compared with bond markets, the risk of investing in foreign stock markets is, to a lesser degree, attributable to exchange rate uncertainty. Exhibit 11.7 indicates that while exchange rates are less volatile than stock market returns, they will contribute substantially to the risk of foreign stock investments.

International bond investment. Although the world bond market is comparable in terms of capitalization value to the world stock market, so far it has not received as much attention in international investment literature. This may reflect, at least in part, the perception that exchange risk makes it difficult to realize gains from international bond diversification.

Existing studies show that when investors control exchange risk by using currency forward contracts, they can substantially enhance the efficiency of international bond portfolios. When exchange risk is hedged, international bond portfolios tend to dominate international stock portfolios in terms of risk-return efficiency.

The common European currency is likely to alter the risk-return characteristics of the affected markets. Although the euro zone bonds differ in terms of credit risk, their risk-return characteristics will converge to a certain extent. This implies that non-euro currency bonds like British bonds would play an enhanced role in international diversification strategies as they would retain their unique risk-return characteristics.

International mutual funds: a performance evaluation. Investors can achieve international diversification at home simply by investing in home-based international mutual funds, which have proliferated in recent years.

By investing in international mutual funds investors can:

1. Save any additional transaction and/or information costs they may have to incur when they attempt to invest directly in foreign markets;

2. Circumvent many legal and institutional barriers to direct portfolio investments in foreign markets;

3. Potentially benefit from the expertise of professional fund managers.

These advantages of international mutual funds should be particularly appealing to small individual investors who would like to diversify internationally but have neither the necessary expertise nor the direct access to foreign markets.

International diversification through country funds. Recently, country funds have emerged as one of the most popular means of international investment in the US as well as in other well-developed countries. A country fund invests exclusively in stocks of a single country. Using these funds, investors can

1. Speculate in a single foreign market with minimum costs

2. Construct their own personal international portfolios using country funds as building blocks.

3. Diversify into emerging markets that are otherwise practically inaccessible.

The majority of the country funds available have a close-end status. A closed-end country fund (CECF) issues a given number of shares that trade on the stock exchange of the host country as if the fund were an individual stock by itself. The fund cannot be redeemed at the underlying net asset value set at the home market of the fund. Since the share value of a US-based fund is set on a US stock market, it may very well diverge from the underlying net asset value (NAV) set in the fund’s home market. The difference is known as a premium if the fund share value exceeds the NAC, or a discount in the opposite case. The underlying assets held outside the US generate cash flows from US-based CECFs. But, the market values of those CECFs are determined in the US, and they often diverge from the NAVs. The nature of CECFs suggests that they may behave partly like securities of the country in which they are traded and partly like securities of the home market.

For US-based CECFs there is a two-factor model:

While CECFs behave more like US securities, they provide US investors with the opportunity to achieve international diversification at home without incurring excessive transaction costs. The majority of CECFs retain significant home market betas, allowing US investors to achieve international diversification to a certain extent.

Exhibit 11.13 shows that the NAVs offer superior diversification opportunities compared to the CECFs. Consequently, those who can invest directly in foreign markets without incurring excessive costs are advised to do so. However, for the majority of investors without such opportunities, CECFs will still offer a cost-effective way of diversifying internationally. Countries funds from emerging countries receive significant weights in the optimal portfolio of CECFs; they can play an important role in expanding the investment opportunity set for international investors.

International diversification with ADRs. US investors can achieve international diversification at home using American depository receipts (ADR) for foreign shares held in the US (depository) banks’ foreign branches or custodians. ADRs are traded on US exchanges like domestic American securities. In this light, US investors can save transaction costs and also benefit from speedy and dependable disclosures, settlements, and custody services.

Using ADRs could substantially reduce risk. Investors should consider the relative advantages and disadvantages of ADRs and CECFs as a means of international diversification. Compared with ADRs, CECFs are likely to provide more complete diversification.

International diversification with WEBS. World Equity Benchmark Shares (WEBS) are exchange-traded funds (ETFs) that are designed to closely track foreign stock market indexes. The American stock exchange (AMEX) had previously introduced a similar security for the US market, Standard & Poor’s Depository Receipts (SPDRs), known as spiders, that is designed to track the S&P 500 Index.

Using exchange-traded funds (ETFs) like WEBS and spiders, investors can trade a whole stock market index as if it were a single stock. Being open-end funds, WEBS trade at prices that are very close to their net asset value. Investors can achieve global diversification instantaneously just by holding shares of the S&P Global 100 Index Fund that is also trading on the AMEX with other WEBS. WEBS were later renamed as iShares, which are listed on multiple exchanges.

International diversification with hedge funds. Hedge funds which represent privately pooled investment funds have experienced a phenomenal growth in recent years, mainly driven by the desire of institutional investors to achieve positive or absolute returns, regardless of whether markets are rising or falling. Hedge fund may adopt flexible, dynamic trading strategies (instead of the typical buy and hold), often aggressively using leverages, short positions, and derivative contracts, in order to achieve their investment objectives.

Legally, hedge funds are private investment partnerships. As such, these funds generally do not register as investment companies and are not subject to any reporting or disclosure requirements. Hedge funds typically receive a management fee, often 1-2 percent of the fund asset value as compensation, plus performance fee that can be 20-25 percent of capital appreciation.

Hedge funds tend to have relatively low correlations with various stock market benchmarks and thus allow investors to diversify their portfolio risk. Also, hedge funds allow investors to access foreign markets that are not easily accessible. While investors may benefit from hedge funds, they need to be aware of the associated risks as well. Hedge funds may make wrong bets based on the incorrect prediction of future events and wrong models.

Home bias in portfolio holdings. Exhibit 11.14 shows the extent of home bias in portfolio holdings. In recent years, investors have begun to invest in foreign securities in earnest. But, most investors still exhibit a strong home bias in portfolio holdings.

1. Domestic securities may provide investors with certain extra services, such as hedging against domestic inflation, that foreign securities do not.

2. There may be barriers, formal / informal, to investing in foreign securities that keep investors from realizing gains from international diversification.

Considering the on-going integration of international financial markets, coupled with the active financial innovation introducing new financial products such as country funds and international mutual funds, home bias may be substantially mitigated in the near future.

International diversification with small-cap stocks. To the extent that investors diversify internationally, well-known, large-cap stocks receive the dominant share of fund allocation. There is no doubt large-cap bias as well as home bias in international investment. These biases are broadly consistent with the proposition that familiarity breeds investment. Increasingly, however, returns to large-cap stocks or stock market indexes that are dominated by large-cap stocks tend to co-move, mitigating the benefit from international diversification (exhibit 11.15).

Many well-known large-cap stock that are popular among international investors are likely to be those of multinational firms with a substantial foreign customer and investor base. In contrast, small-cap firms are likely to be locally oriented with a limited international exposure. As a result, returns on large-cap stock would be substantially driven by common global factors, whereas returns on small-cap stocks are likely to be primarily driven by local factors. This implies that locally oriented, small-cap stock may be an effective vehicle for international diversification.

Chapter 12: Economic exposure management

Due to the increase in globalization, the exposure of firms to risk of fluctuating exchange rates has increased. These fluctuations could affect many aspects of a firm, such as cash flows from contracts denominated in foreign currencies, value of its foreign assets and liabilities, and its competitive position. Changes in exchange rates may affect not only the operating cash flows of a firm by altering its competitive position but also the home currency values of the firm’s assets and liabilities. A negative (positive) forex beta means that the stock returns tend to move down (up) as the dollar appreciates (exhibit 12.1).

Three types of exposure. It is convenient to classify foreign currency exposures into three types:

1. Economic exposure: the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firm’s value.

2. Transaction exposure: the sensitivity of the realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Since settlements of these contractual cash flows affect the firm’s domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure. Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly.

3. Translation exposure: the potential that the firm’s consolidate financial statements can be affected by changes in exchange rates. Consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency. Translation involves many controversial issues. Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex post. It does not provide a good measure of ex ante economic exposure.

Measuring economic exposure. Currency risk / uncertainty (random changes in exchange rates) ≠currency exposure (what is at risk). Under certain conditions, a firm may not face any exposure at all, that is, nothing is at risk, even if the exchange rates change randomly. To the extent that the dollar price of a foreign currency exhibits sensitivity to exchange rate movements, your company is exposed to currency risk. Similarly, if your company’s operating cash flows are sensitive to exchange rate changes, the company is again exposed to currency risk.

Exposure to currency risk (exhibit 12.2) thus can be properly measured by the sensitivities of

1. The future home currency values of the firm’s assets and liabilities;

2. The firm’s operating cash flows to random changes in exchange rates.

Asset exposure. Assume that dollar inflation is non-random, then, from the perspective of the US firm that owns an asset in a foreign country (e.g. Britain), the exposure can be measured by the coefficient (b) in regressing the dollar value (P) of the British asset on the dollar/pound exchange rate (S)

P = a + b * S + e

Where

Based on this equation, one could say that exposure is the regression coefficient. Statistically, the exposure coefficient, b, is defined as

Where

Once the magnitude of the exposure is known, the firm can hedge the exposure by simply selling the exposure forward. We can decompose the variability of the dollar value of the asset, Var(P), into two separate components: exchange rate-related and residual. Specifically,

Var(P) = b² Var(S) + Var(e)

The consequences of hedging the exposure by forward contracts is illustrated in exhibit 12.5.

Operating exposure. While managers understand the effects of random exchange rate changes on the dollar value of their firms’ assets and liabilities denominated in foreign currencies, they often do not fully understand the effect of volatile exchange rates on operating cash flows. As the economy becomes increasingly globalized more firms are subject to international competition. Fluctuating exchange rates can seriously alter the relative competitive positions of such firms in domestic and foreign markets, affecting their operating cash flows.

The exposure of operating cash flows depends on the effect of random exchange rate changes on the firm’s competitive position, which is not readily measureable. This difficulty is notwithstanding, it is important for the firm to properly manage operating exposure as well as asset exposure. Often, operating exposure may account for a larger portion of the firm’s total exposure than contractual exposure. Formally, operating exposure can be defined as the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates.

A domestic currency (dollar) operating cash flow may change following a foreign currency (pound) depreciating due to

1. The competitive effect: a foreign currency (pound) depreciation may affect operating cash flow in foreign currency (pound) by altering the firm’s competitive position in the marketplace.

2. The conversion effect: a given operating cash flow in foreign currency (pound) will be converted into a lower domestic currency (dollar) amount after the foreign currency (pound) deprecation.

Operating exposure determinants. Unlike contractual (i.e. transaction) exposure, which can readily be determined from the firm’s accounting statements, operating exposure cannot be determined in the same manner.

A firm’s operating exposure is determined by

1. The structure of the markets in which the firm sources its inputs, such as labour materials, and sells its products

2. The firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.

The exchange rate pass-through is the relationship between exchange rate changes and the price adjustments of internationally traded goods.

Generally speaking, a firm is subject to high degrees of operating exposure when either its cost or its price is sensitive to exchange rate changes. On the other hand, when both the cost and the price are sensitive or insensitive to exchange rate changes, the firm has no major operating exposure.

Given the market structure, however, the extent to which a firm is subject to operating exposure depends on the firm’s ability to stabilize cash flows in the face of exchange rate changes. The firm’s flexibility regarding production locations, sourcing, and financial hedging strategy is an important determinant of its operating exposure to exchange risk.

It is important to note that changes in nominal exchange rates may not always affect the firm’s competitive position. This is the case when a change in exchange rate is exactly offset by the inflation differential.

Next, it is useful to examine the relationship between exchange rate changes and the price adjustment of goods. Facing exchange rate changes, a firm may choose one of the following three pricing strategies:

1. Pass the cost shock fully to its selling prices  complete pass-through.

2. Fully absorb the shock to keep its selling prices unaltered  no pass-through.

3. Do some combination of the two strategies described above  partial pass through.

Import prices in the US do not fully reflect exchange rate changes, exhibiting a partial pass-through phenomenon.

In a comprehensive study, Yang (1997) investigated exchange rate pass-through in US manufacturing industries during the sample period 1980-1991 and found that the pricing behaviour of foreign exporting firms is generally consistent with partial pass-through (exhibit 12.11). it is noteworthy that partial pass-through is a common but varies a great deal across industries. Import prices would be affected relatively little by exchange rate changes in industries with a low degree of product differentiation, and, thus, high demand elasticities. On the contrary, in industries with a high degree of product differentiation, and, thus, low demand elasticities, import prices will tend to change more as the exchange rates change, limiting exposure to exchange risk.

Operating exposure management. With increasing globalization, many firms are engaged in international activities such as exports, cross-border sourcing, and joint ventures with foreign partners, and establishing production and sales affiliated abroad. The cash flows of such firms can be quite sensitive to exchange rate changes. The objective of managing operating exposure is to stabilize cash flows in the face of fluctuating exchange rates.

Since a firm is exposed to exchange risk mainly through the effect of exchange rate changes on its competitive position it is important to consider exchange exposure management in the context of the firm’s long-term strategic planning. Managing operating exposure is thus not a short-term tactical issue.

The firm can use the following strategies for managing operating exposure:

1. Selecting low-cost production sites;

2. Flexible sourcing policy;

3. Diversification of the market;

4. Product differentiation and R&D efforts;

5. Financial hedging.

Selecting low-cost production sites. When the domestic currency is strong or expected to become strong, eroding the competitive position of the firm, it can choose to locate production facilities in a foreign country, where costs are low due to either the undervalued currency or under-priced factors of production.

Also, the firm can choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes. Maintaining multiple manufacturing sites, however, may prevent the firm from taking advantage of economies of scale, raising its costs of production. The resultant higher cost can partially offset the advantages of maintaining multiple production sites.

Flexible sourcing policy. Even if the firm has manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes by sourcing from where input costs are low. A flexible sourcing policy need not be confined just to materials and parts. Firms can also hire low-cost guest worker from foreign countries instead of high-cost domestic workers in order to be competitive.

Diversification of the market. Another way of dealing with exchange exposure is to diversify the market for the firm’s products as much as possible. As long as exchange rates do not always move in the same direction, the firm can stabilize its operating cash flows by diversifying its export market.

It is sometimes argued that the firm can reduce currency exposure by diversifying across different business lines. Consequently, the idea is that although each individual business may be exposed to exchange risk to some degree, the firm as a whole may not face a significant exposure. It is pointed out, however, that the firm should not get into new lines of business solely to diversify exchange risk because conglomerate expansion can bring about inefficiency and losses. Expansion into a new business should be justified on its own right.

R&D efforts and product differentiation. Investment in R&D activities can allow the firm to maintain and strengthen its competitive position in the face of adverse exchange rate movements. Successful R&D efforts allow the firm to cut costs and enhance productivity. Additionally, R&D efforts can lead to the introduction of new and unique products for which competitors offer no close substitutes. Since the demand for unique products tend to be highly inelastic (i.e. price insensitive), the firm would be less exposed to exchange risk. Simultaneously, the firm can strive to create a perception among consumers that its product is indeed different from those offered by competitors. Once the firm’s product acquires a unique identity, its demand is less likely to be price-sensitive.

Financial hedging. While not a substitute for the long term, operational hedging approaches discussed above, financial hedging can be used to stabilize the firm’s cash flows. For example, the firm can lend/borrow foreign currencies on a long-term basis. Or, the firm can use currency forward or option contracts and roll them over if necessary.

It is noted that existing financial contracts are designed to hedge against nominal, rather than real, changes in exchange rates. Since the firm’s competitive position is affected by real changes in exchange rates, financial contracts can at best provide an approximate hedge against the firm’s operating exposure. However, if operational hedges, which involve redeployment of resources, are costly or impractical, financial contracts can provide the firm with a flexible and economical way of dealing with exchange exposure.

Chapter 14: translation exposure management

Many firms have subsidiaries located in foreign countries. Changes in exchange rates result in changes in translated values. Translation exposure refers to the effect that un anticipated change in exchange rates will have on the consolidated financial statements of a firm. Translation exposure is also frequently called accounting exposure.

Four methods of foreign currency translation have been used in recent years:

1. The current / noncurrent method;

2. The monetary / nonmonetary method;

3. The temporal method;

4. The current rate method.

Current / noncurrent method. The current / noncurrent method of foreign currency translation was generally accepted in the US from the 1930s until 1975, when FASB 8 became effective. The underlying principle of this method is that assets and liabilities should be translated based on their maturities.

• Current assets and liabilities, which by definition have a maturity of one year or less, are converted at the current exchange rate.

• Noncurrent assets and liabilities are translated at the historical exchange rate in effect at the time the asset or liability was first recorded on the books.

Under this method, a foreign subsidiary with current assets in excess of current liabilities will cause a translation gain (loss) if the local currency appreciates (depreciates). The opposite will happen if there is a negative net working capital in local terms of the foreign subsidiary.

Most income statement items under this method are translated at the average exchange rate for the accounting period. However, revenue and expense items that are associated with noncurrent assets or liabilities, such as depreciation expense, are translated at the historical rate that applies to the applicable balance sheet item.

Monetary / nonmonetary method. According tot the monetary / nonmonetary method, all monetary balance sheet accounts (e.g. cash, marketable securities, accounts receivable etc.) of a foreign subsidiary are translated at the current exchange rate. All other (nonmonetary) balance sheet accounts, including stockholders’ equity, are translated at the historical exchange rate in effect when the account was first recorded.

In comparison to the current / noncurrent method, this method differs substantially with respect to accounts such as inventory, long-term receivables, and long-term debt. The underlying philosophy of the monetary / nonmonetary method is that the monetary accounts have a similarity because of their value represents a sum of money whose currency equivalent after translation changes each time the exchange rate changes. This method classifies accounts on the basis of similarity of attributes rather than similarities of maturities.

Under this method, most income statements are translated at the average exchange rate for the period. However, revenue and expense items associated with nonmonetary accounts, such as cost of goods sold and depreciation, are translated at the historical rate associated with the balance sheet account.

Temporal method. Under the temporal method, monetary accounts such as cash, receivables and payables (both current and noncurrent) are translated at the current exchange rate. Other balance sheets accounts are translated at the current rate, if they are carried on the books at current value; if they are carried at historical costs, they are translated at the rate of exchange on the date the item was placed on the book.

Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary / nonmonetary method will typically provide the same translation. Nevertheless, the underlying philosophies of the two methods are entirely different. Under current value accounting, all balance sheet accounts are translated at the current exchange rate.

Under the temporal method, most income statement items are translated at the average exchange rate for the period. Depreciation and cost of goods sold, however, are translated at historical rates if the associated balance sheet accounts are carried at historical costs.

Current rate method. Under the current rate method, all balance sheet accounts are translated at the current exchange rate, except for stockholders’ equity. This is the simplest of all translation methods to apply. The common stock account and any additional paid-in capital are carried at the exchange rates in effect on the respective dates of issuance. Year-end retained earnings equal the beginning balance of retained earnings plus any additions for the year. A plug equity account named cumulative translation adjustment (CTA) is used to make the balance sheet balance, since translation gains or losses do not go through the income statement according to this method.

Under the current rate method, income statement items are to be translated at the exchange rate at the dates the items are recognized. Since this is generally impractical, an appropriately weighted average exchange rate for the period may be used for the translation.

Financial accounting standards board statement 8. FASB 8 was implemented on January 1, 1976. It objective was to measure in dollars an enterprise’s assets, liabilities, revenues, or expenses that are denominated in a foreign currency according to generally accepted accounting principles.

FASB 8 is essentially the temporal method of translation as previously defined, but there are some subtleties. FASB 8 ran into acceptance problems from the accounting profession and MNCs from the very beginning. The temporal method requires taking foreign exchange gains / losses through the income statement (example 14.1). Consequently, reported earnings could, and did, fluctuate substantially from year to year, which was irritating to corporate executives.

Additionally, many MNCs did not like translating inventory at historical rates, which was required if the firm carried the inventory at historical values, as most did, and do. It was felt that it would be much simpler to translate at the current rate.

Financial accounting standards board statement 52. FASB 52 was issued in December 1981. Its stated objectives are to

1. Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity;

2. Reflect in consolidated statement the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with US generally accepted accounting principles.

Many discussions of FASB 52 claim that it is a current rate method of translation. However, this is not true, as FASB 52 requires the current rate method of translation in some circumstances and the temporal method in others.

The functional currency is defined in FASB 52 as the currency of the primary economic environment in which the entity operates. Normally, that is the local currency of the country in which the entity conducts most of its business. However, under certain circumstances, the functional currency may be the parent firm’s home country currency or some third-country currency (exhibit 14.2).

The reporting currency is defined as the currency in which the MNC prepares its consolidated financial statements. That currency is usually the currency in which he parent firm keeps the books, which in turn is usually the currency of the country in which the parent is located and conducts most of its businesses. However, the reporting currency could be some third currency.

The mechanisms of the FASB 52 translation process. The actual translation process prescribed by FASB 52 is a two-stage process.

1. It is necessary to determine in which currency the foreign entity keeps its books. If the local currency in which the foreign entity keeps its book is not the functional currency, remeasurement into the functional currency is required. Remeasurement is intended to product the same result as if the entity’s books had been maintained in the functional currency. The temporal method of translation used to accomplish the remeasurement.

2. When the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated from the functional currency into the reporting currency using the current rate method. Obviously, translation is not required if the foreign entity’s functional currency is the same as the reporting currency.

Highly inflationary economies. In highly inflationary economies, FASB 52 requires that the foreign entity’s financial statements be remeasured from the local currency as if the functional currency were the reporting currency using the temporal translation method. A highly inflationary economy defined as one that has cumulative inflation of approximately 100 percent or more over a 3-year period.

The purpose of this requirement is to prevent large import balance sheet accounts, carried at historical values, from having insignificant values one translated into the reporting currency at the current rate. We know that according to relative purchasing power parity a currency from a higher inflationary economy will depreciate relative to the currency of a lower inflationary economy by approximately the differential of the two countries’ inflation rates.

International accounting standards. Markets have become more integrated as a result of cross-border investing and financing, international accounting standards that provide a common accounting language are gaining acceptance. A common set of high-quality global standards is a priority of the International Accounting Standards (IAS) and the FASB.

Management of translation exposure. In general it is not possible to eliminate both translation and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other one. But in other cases, the elimination of one exposure usually creates the other one. Since transaction exposure involves real cash flows, we believe it should be considered the more important of the tow. That is, the financial manager would not want to legitimately create transaction exposure at the expense of minimizing or elimination transaction exposure.

Hedging translation can be done using two different methods:

1. Balance sheet hedge;

2. Derivatives hedge.

Balance sheet hedge. Translation exposure is currency specific rather than entity specific. Its source of a mismatch of net assets and net liabilities denominated in the same currency. A balance sheet hedge eliminates the mismatch. A perfect balance sheet hedge would be created when a change in the foreign/dollar (e.g. €/$) exchange rate would have not longer any effect on the consolidated balance sheet since the change in value of the assets denominated in euros would completely offset the change in value of the liabilities denominated in foreign currency (e.g. €).

Derivatives hedge. If one desires, a derivative product, such as a forward contract, can be used to attempt to hedge the potential loss. Using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes.

In 1998, FASB 133 was issued. This statement establishes accounting and reporting standards for derivative instruments and hedging activities. To qualify for hedge accounting under FASB 133, a company must identify a clear link between an exposure and a derivative instrument. FASB 133 clarifies which transactions qualify as an acceptable hedge and how to treat unexpected gain or loss if the hedge is not effective.

An unhedged depreciation will result in an equity loss. Such a loss would only be a loss on paper. It would not have any direct effect on reporting currency cash flows. It would only have a realizable effect net investment in the MNC if the affiliate’s assets were sold of liquidated.

Chapter 20: International tax environment

The objectives of taxation. Two basic objectives of taxation have to be discussed to help frame our thinking about the international tax environment: tax neutrality and tax equity.

Tax neutrality has its foundations in the principles of economic efficiency and equity. It is determined by 3 criteria:

1. Capital-export neutrality is the criterion than an ideal tax should be effective in raising revenue for the government and not have any negative effects on the economic decision making process of the taxpayer. That is, a good tax is one that is efficient in raising tax revenue for the government en does not prevent economic resources from being allocated to their most appropriate use no matter where in the world the highest rate of return can be earned.

2. National neutrality, that is, taxable income is taxed in the same manner by the taxpayer’s national tax authority regardless of where in the world it is earned. In practice, this is a difficult concept to apply.

3. Capital–import neutrality, this criterion implies that the tax burden a host country imposes on the foreign subsidiary of a MNC should be the same regardless of the country in which the MNC is incorporated and the same as that placed on domestic firms. Implementing capital-import neutrality means that if the US tax rate were greater than the tax rate of a foreign country in which a US MNC earned foreign income, additional tax on that income above the amount paid to the foreign tax authority would not be due in the US> the concept of capital-import neutrality, like national neutrality, is based on the principle of equality, and its implementation provides a level competitive playing field for all participants in a single marketplace, at least with respect to taxation. Nevertheless, the implementation means that a sovereign government follows the taxation policies of foreign tax authorities on the foreign-source income of its resident MNCs and that domestic taxpayers end up paying a larger portion of the total tax burden.

Obviously, the three criteria of tax neutrality are not always consistent with one another.

The underlying principle of tax equity is that all similarly situated taxpayers should participate in the cost of operating the government according to the same rules. This means that regardless of the country in which an affiliate of a MNC earns taxable income, the same tax rate and tax due date apply. The principle of tax equity is difficult to apply; the organizational form of a MNC can affect the timing of a tax liability.

Types of taxation. Many countries in the world obtain a significant portion of their tax revenue from imposing an income tax on personal and corporate income. An income tax is a direct tax – that is, one that is paid directly by the taxpayer on whom it is levied. The tax is levied on active income – that is, income that results from production by the firm or individual or from services that have been provided.

A withholding tax is a tax generally levied on passive income earned by an individual or corporation of one country within the tax jurisdiction of another country. Passive income includes dividends and interest income, and income from royalties, patents, or copyrights paid to the taxpayer by a corporation. It is an indirect tax that is borne by a taxpayer who did not directly generate the income.

Many countries have tax treaties with one another specifying the withholding tax rate applied to various types of passive income (exhibit 20.2). For specific types of passive income, the tax rates may be different from those presented in exhibit 20.2. Withholding tax rates vary by category of passive income from 0 to 30 percent.

A value-added tax (VAT) is an indirect national tax levied on the value added in the production of a good (or service) as it moves through the various stages of production. There are several ways to implement a VAT. The subtraction method is frequently used in practice.

Many economists prefer a VAT in place of a personal income tax, because the latter is a disincentive to work, whereas a VAT discourages unnecessary consumption; VAT fosters national saving. A problem with a VAT, especially in de EU, is that not all countries impose the same VAT tax rate, encouraging shipping from high VAT country to the low VAT country.

National tax environments. The international tax environment confronting a MNC or an international investor is a function of the tax jurisdictions established by the individual countries in which the MNC does business or in which the investor owns financial assets. There are two fundamental types of tax jurisdiction:

1. Worldwide;

2. Territorial.

The worldwide or residential method of declaring a national tax jurisdiction is to tax national residents of the country on their worldwide income no matter in which country it is earned. The national tax authority is declaring its tax jurisdiction over people and businesses. If the host country of the foreign affiliates of a MNC also tax the income earned within their territorial borders, the possibility of double taxation exists, unless there is a mechanism established to prevent it.

The territorial or source method of declaring a tax jurisdiction is to tax all income earned within the country by any taxpayer, domestic or foreign. Regardless of the nationality of a taxpayer, if the income is earned within the territorial boundary of a country that country taxes it.

In a given tax year, an overall limitation applies to foreign tax credits – that is, the maximum total tax credit is limited to the amount of tax that would be due on the foreign-source income if it had been earned in de US. The maximum tax credit is figured on worldwide foreign-source income; losses in one country can be used to offset profits in another. Excess tax credits for a tax year can be carried back one year and forward ten years.

Individual US investors may take a tax credit for the withholding taxes deducted from the dividend and interest income they received from the foreign financial assets in their portfolios.

Organizational structures. There are differences among countries in how foreign-source income of domestic MNCs is taxed. Different forms of structuring a MNC within a country can result in different tax liabilities for the company.

An overseas affiliate of a US MNC can be organized as a branch or a subsidiary. A foreign branch is not an independently incorporated firm separate from the parent; it is an extension of the parent. Active or passive foreign-source income earned by the branch is consolidated with the domestic-source income of the parent for determining the US tax liability, regardless of whether or not the foreign-source income has been repatriated to the parent.

A foreign subsidiary is an affiliate organization of the MNC that is independently incorporated in the foreign country, and one in which the US MNC owns at leas 10 percent of the voting equity stock. One in which the US MNC owns more than 10 percent but less than 50 percent of the voting equity is a minority foreign subsidiary or an uncontrolled foreign corporation. When the MNC owns more than 50 percent of the voting equity then it is called a controlled foreign corporation.

A tax haven country is one that has a low corporate income tax rate and low withholding tax rates on passive income (exhibit 20.1). tax havens were once useful as locations for a MNC to establish a wholly owned paper foreign subsidiary that in turn would own the operating foreign subsidiaries of the MNC. Hence, when the tax rates in the host countries of the operating affiliates were lower than the tax rate in the parent country, dividends could be routed through the tax haven affiliate for use by the MNC, but the taxes due on them in the parent country could continue to be deferred until a dividend was declared by the tax haven subsidiary.

Nowadays, the benefit of using a tax haven subsidiary for US MNCs has greatly reduced, because of

1. The present corporate income tax rate in the US is not especially high in comparison to most non-tax haven countries, thus eliminating the need for deferral;

2. The rules governing controlled foreign corporations have effectively eliminated the ability to defer passive income in a tax haven foreign subsidiary.

A controlled foreign corporation (CFC) is a foreign subsidiary that has more than 50 percent of its voting equity owned by US shareholders – that is, any US citizen, resident, partnership, corporation, trust, or estate than owns (or indirectly controls) 10 percent or more of the voting equity of the CFC.

In case of a CFC, certain types of undistributed income, known as Subpart F income, are subject to immediate taxation. In 2006, Congress passed the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005 that redefined Subpart F income. Under TIPRA, Subpart F income includes: insurance income; foreign base company income (i.e. passive, sales, shipping, and oil-related income); income from countries subject to international boycotts; illegal bribes, kickback, or similar payments; and income from countries where the US has severed diplomatic relations.

Transfer pricing and related issues. Within a large business firm with multiple divisions, goods, and services are frequently transferred from one division to another. The process brings into question the transfer price that should be assigned, for bookkeeping purposes, to the goods or services as they are transferred between divisions. The higher the transfer price, the larger will be the gross profits of the transferring division relative to the receiving division. Overall, it is difficult to decide on the transfer price. Within a MNC, the decision is further compounded by exchange restrictions on the part of the host country where the receiving affiliate is located, a difference in income tax rates between the two countries and import duties and quotas imposed by the host country.

Transfer pricing strategies may be beneficial when the host country restricts the amount of foreign exchange that can be used for importing specific goods. In this event, a lower transfer price allows a greater quantity of the food to be imported under a quota restriction. This may be a more important consideration than income tax savings, if the imported item is a necessary component needed by an assembly or manufacturing affiliate to continue or expand production.

Also, transfer prices have an effect on how divisions of a MNC are perceived locally. A high mark-up policy leaves little net income to show on the affiliate’s books. If the parent firm expects the affiliate to be able to borrow short-term funds locally in the event of a cash shortage, the affiliate may have difficulty doing so with unimpressive financial statements. On the contrary, a low mark-up policy makes it appear, at least superficially, as if affiliates, rather than the parent firm, are contributing a larger portion to consolidated earnings.

A very low mark-up policy makes the adjusted present value (APV) of a subsidiary’s capital expenditure appear more attractive. On the other hand, a very high mark-up policy makes the adjusted present value (APV) of a subsidiary’s capital expenditure appear less attractive. In order to obtain meaningful analysis, arm’s-length pricing should be used in the APV analysis to determine after-tax operating income, regardless of the actual transfer price employed. A separate term in the APV analysis can be used to recognize tax-savings from transfer pricing strategies.

An advance pricing agreement (APA) is a binding contract between the US IRS and a multinational firm by which the IRS agrees to not seek a transfer pricing adjustment under section 482 of the Internal Revenue Code for some set of transactions called covered transactions. The agreement provide means to resolve transfer pricing issues before they arise in an audit. It increase the efficiency of tax administration by encouraging taxpayers to present to the IRS all relevant information for it to properly conduct a transfer pricing analysis.

APAs can be unilateral, bilateral, or multilateral:

• A unilateral APA involves a negotiated transfer pricing method (TPM) between the taxpayer and the IRS for US tax purposes.

• A bilateral / multilateral APA is an agreement between the taxpayer and one or more foreign tax administrations under the mutual agreement procedure specified in tax treaties. The taxpayer is assured that the income associated with covered transaction will not be subject to double taxation by any taxing authority.

Consequently, they are of benefit to the tax payer.

Blocked funds. a country may find itself short of foreign currency reserves, and thus impose exchange restrictions on its own currency, limiting its conversion into other currencies so as not to further reduce scarce foreign currency reserves. When a country enforces exchange controls, the remittance of profits from a subsidiary to its parent is blocked. Without the ability to repatriate profits from a foreign subsidiary, the MNC might as well not even have the investment, as returns are not being paid to the stockholders of the MNC. This is a political risk which the MNC must contend.

Leading and lagging payments may be used as a strategy for repositioning funds within a MNC. Additional strategies that may be useful for moving blocked funds are

• Export creation; and

• Direct negotiation.

Export creation involves using the blocked funds of a subsidiary in the country in which they are blocked to pay for exports that can be used to benefit the parent firm or other affiliates.

Host countries desire to attract foreign industries that will most benefit their economic development and the technical skills of their citizens. Thus, foreign investment in the host country in industries that produce export goods, or in industries that will attract tourists, is desirable. The host country should not expect a MNC to make beneficial investment within its borders if it is not likely to receive an appropriate return. Consequently, MNCs in desirable industries may be able to convince the host country government through direct negotiation that funds blockage is detrimental to all.

Chapter 21: Corporate governance around the world

The primary goal of financial management is maximizing the wealth of shareholders. However, excessive managerial self-dealings can have serious negative effects on corporate values and the proper functioning of capital markets. In fact, there is a growing consensus around the world that it is vitally important to strengthen corporate governance to protect shareholder rights, curb managerial excess, and restore confidence in capital markets. Corporate governance can be defined as the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company. Other stakeholders may include workers, creditors, banks, institutional investors, and even the government.

Key issues in the governance of a public corporation. The public corporation, which is jointly owned by a multitude of shareholders protected by limited liability, is a major organizational innovation with powerful economic consequences. The genius of public corporations stems from their capacity to allow efficient sharing or spreading of risk among many investors, who can buy and sell their ownership shares on liquid stock exchanges and let professional managers run the company on behalf of shareholders. The efficient risk sharing mechanism enables public corporations to raise large amounts of capital at relatively low costs and undertake many investment projects that individual entrepreneurs or private investors might eschew because of the costs and/or risks.

The public corporation has a key weakness – that is, the conflicts of interest between managers and shareholders. The separation of ownership and control, which is especially prevalent in such countries as the US and UK, where corporate ownership is highly diffused, give rise to possible conflicts between shareholders and managers. It is suggested that outside the US and UK, diffused ownership of the company is more the exception than the rule. In a public company with diffused ownership, the board of directors is entrusted with the vital tasks of monitoring the management and safeguarding the interest of shareholders.

In real-life, management-friendly insiders often dominate the board of directors, with relatively few outside directors who can independently monitor the management. Besides, with diffused ownership, few shareholders have strong enough incentive to incur the costs of monitoring management themselves when the benefits from such monitoring accrue to all shareholders alike. The benefits are shared, but the costs are not. When company ownership is highly diffused, this free rider problem discourages shareholder activism. This leads to divergence between the interest of the managers and shareholders.

In a series of influential studies of La Porta, Lopez-de-Silanes, Shleifer, & Vishny (LLSV) document serveral differences among countries with regard to

1. Corporate ownership structure;

2. Depth an breadth of capital markets;

3. Access of firms to external financing;

4. Dividend policies.

LLSV suggest that the degree of legal protection of investors significantly depends on the legal origin of countries. English common law countries provide the strongest protection for investors.

The central problem in corporate governance is how to best protect outside investors from expropriation by the controlling insiders so that the former can achieve fair returns on their investments.

The agency problem. If the manager and the investors can write a complete contract that specifies exactly what the manager will do under each of all possible future contingencies, there will be no room for any conflicts of interest or managerial discretion. Therefore, under a complete contract, there will be no agency problem.

In practice, it is impossible to foresee all future contingencies and write a complete contract, meaning that the manager and the investors will have to allocate the rights (control) to make decisions under those contingencies that are not covered by the contract. Since the outside investors may be neither qualified nor interested in making business decisions, the mangers often ends up acquiring most of this residual control right. The agency problem refers to the possible conflicts of interest between self-interested managers as agents and the shareholders begin the principals.

Self-interest managers may waste funds by undertaking unprofitable projects that benefit themselves but not investors. These types of investment will destroy shareholder value. The managers may adopt antitakeover measures for their own company in order to ensure their personal job security and perpetuate private benefits. In the same vein, managers must resist any attempts to be replaced even if shareholders'’ interest will be better served by their dismissal. These managerial entrenchment efforts are clear signs of the agency problem.

The agency problem becomes more serious in companies with free cash flows. Free cash flows represents a firm’s internally generated funds in excess of the amount needed to undertake all profitable investment projects – that is, those with positive net present values (NPVs). Free cash flows tend to be high in mature industries with low future growth prospects.

There are a few important incentives for managers to retain cash flows:

1. Cash reserves provide corporate managers with a measure of independence from the capital markets, insulating them from external scrutiny and discipline. This will make life easier for managers

2. Growing the size of the company via retention of cash tends to have the effect of raising managerial compensation. Executive compensation depends as much on the size of the company as on its profitability, if not more.

3. Senior executives can boost their social and political power and prestige by increasing the size of their company. Executives presiding over large companies are likely to enjoy greater social prominence and visibility than those running small companies.

Remedies for the Agency Problem. Several governance mechanisms exist to alleviate or remedy the agency problem:

1. Board of directors;

2. Incentive contracts;

3. Concentrated ownership;

4. Accounting transparency;

5. Debt;

6. Overseas stock listing;

7. Market for corporate control.

Board of directors. If the board of directors remains independent of management, it can serve as an effective mechanism for curbing the agency problem. In the case of diffused ownership, management often gets to choose board members who are likely to be friendly to management.

Incentive contracts. When professional managers have small equity positions of their own in a company with diffused ownership, they have both power and a motive to engage in self-dealings. Many companies provide managers wit incentive contracts, such as stocks and stock options, in order to reduce this wedge and better alight the interests of managers with those of investors.

Concentrated ownership. If one or a few large investors own significant portions of the company, they will have a strong incentive to monitor management. With concentrated ownership and high stakes, the free-rider problem afflicting small, atomistic shareholders dissipates.

Accounting transparency. Strengthening accounting standards can be an effective way of alleviating the agency problem. Self-interested managers or corporate insiders can have an incentive to cook the books to extract private benefits from the company. If companies are required to release more accurate accounting information in a timely fashion, managers may be less tempted to take actions that are detrimental to the interest of shareholders.

However, to achieve a greater transparency, it is important for

1. Countries to reform their accounting rules;

2. Companies to have an active and qualified audit committee.

Debt. Although managers have discretion over how much of a dividend to pay to shareholders, debt does not allow such managerial discretion. If managers fail to pay interest and principal to creditors, the company can be forced into bankruptcy and its managers may lose their jobs. Borrowing and the subsequent obligation to make interest payments on time can have a major disciplinary effect on managers, motivating them to curb private perks and wasteful investments and trim bloated organizations. For firms with free cash flows, debt can be a stronger mechanism than stocks for credibly bonding managers to release cash flows to investors.

On the other hand, excessive debt can create its own problem. In turbulent economic conditions, equities can buffer the company against adversity. With debt, managers have less flexibility, and cannot pare down or skip dividend payments until the situation improves. Debt might not be the best mechanism for young companies with few cash reserves or tangible assets.

Overseas stock listings. Foreign firms with weak governance mechanisms can opt to outsource a superior corporate governance regime available in the US via cross-listings. The beneficial effects from US listings will be greater for firms from countries with weaker governance mechanisms than from countries with stronger ones.

Market for corporate control. If a company continually performs poorly and all of its internal governance mechanisms fail to correct the problem, then an outsider (another company or investor) may issue a takeover bid. In a hostile takeover attempt, the bidder typically makes a tender offer to the target shareholders at a price substantially exceeding the prevailing share price. The target shareholders get an opportunity to sell their shares at a substantial premium.

If the bid is successful, the bidder will acquire the control rights of the target and restructure the company. Then, often the management team is replaced, some divisions will be disinvested, and the employment will be trimmed in an effort to enhance efficiency. If these actions are successful, the combined market value of the acquirer and target companies will become higher than the sum of stand-alone values of the two companies, reflecting the synergies created. The market for corporate control, if it exists, can have a disciplinary effect on managers and enhance company efficiency.

Law and corporate governance. Legal scholars show that the commercial legal system (e.g. company, security, bankruptcy, and contract laws) of most countries derive from relatively legal origins:

• English common law;

• French civil law;

• German civil law;

• Scandinavian civil law.

The civil law tradition, which is the most influential and widely spread, is based on the comprehensive codification of legal rules. In contrast, English common law is formed by the discrete rulings of independent judges on specific disputes and judicial precedent. These distinct legal systems, especially English common law and French civil law, spread around the world through conquest, colonization, voluntary adoption, and subtle imitation.

In England, the control of the court passed form the crown to Parliament and property owners in the 17th century. English common law thus become more protective of property owners, and this protection was extended to investors over time. In France, as well as Germany, parliamentary power was weak and commercial laws were codified by the state, with the role of the court confined to simply determining whether the codified rules were violated or not. Since managers can be creative enough to expropriate investors without obviously violating the codified rules, investors receive low protection in civil law countries.

Consequences of law. Concentrated ownership can be viewed as a rational response to weak investor protection, but it may create a different agency conflict between large controlling shareholders and small outside shareholders. If large shareholders benefit only from pro-rate cash flows, there will be no conflicts between large shareholders and small shareholders. Since investors may be able to derive private benefits from control, they may seek to acquire control rights exceeding cash flow rights.

Dominant investors may acquire control through various schemes, such as:

1. Shares with superior voting rights;

2. Pyramidal ownership structure;

3. Inter-firm cross-holdings.

Many companies issue shares with differential voting rights, deviating from the one-share one-vote principle. By accumulating superior voting shares, investors can acquire control rights exceeding cash flow rights. Besides, large shareholders, who are often founders and their families, can use a pyramidal ownership structure in which they control a holding company that owns a controlling block of another company, which, in turn, owns controlling interest in yet another company, and so on. Furthermore, equity cross-holdings among a group of companies, such as keiretsu and chaebols, can be used to concentrate and leverage voting rights to acquire control. Obviously, a combination of these schemes may be used to acquire control.

Once large shareholders acquire control rights exceeding cash flow rights, they may extract private benefits of control that are not shared by other shareholders on a pro-rate basis.

When investors are assured of receiving fair returns on their funds, they will be willing to pay more for securities. To the extent that this induces companies to seek more funds from outside investors, strong investor protection, strong investor protection will be conductive to large capital markets.

Weak investor protection can be also a contributing factor to sharp market declines during a financial crisis. In countries with weak investor protection, insiders may treat outside investors reasonably well as long as business prospect warrant continued external financing. But, once future prospects dim, insiders may start to expropriate the outside investors as the need for external funding dissipates. The accelerated expropriation can induce sharp declines in security prices. The existence of well-developed financial markets, promoted by strong investor protection, may stimulate economic growth by making funds readily available for investment at low cost.

Financial development can contribute to economic growth in three major ways:

1. It enhances savings;

2. It channels savings toward real investment in productive capacities, thereby fostering capital accumulation;

3. It enhances the efficiency of investment allocation through the monitoring and signalling functions of capital markets.

Corporate governance reform. Failure to reform corporate governance will damage investor confidence, stunt the development of capital markets, raise the cost of capital, distort capital allocation, and even shake confidence in capitalism itself.

There is a growing consensus that corporate governance reform should be a matter of global concern. Although some countries face more serious problems than others, existing governance mechanisms have failed to effectively protect outside investors in many countries. The objective should be: strengthen the protection of outside investors from expropriation by managers and controlling insiders.

Among other things, reform requires:

1. Strengthening the independence of board of directors with more outsiders;

2. Enhancing the transparency and disclosure standard of financial statements;

3. Energizing the regulatory and monitoring functions of the SEC (in the US) and stock exchanges.

In many developing countries it may be necessary to first modernize the legal framework.

However, governance reform is easier said than done:

1. The existing governance system is a product of the historical evolution of the country’s economic, legal, and political infrastructure. It is not easy to change historical legacies.

2. Many parties have vested interests in the current system, and they will resist any attempt to change the status quo.

To be successful, reformers should understand the political dynamics surrounding governance issues and seek help from the media, public opinion, and nongovernmental organizations (NGOs).

Facing public uproar following the US corporate scandals, politicians took actions to remedy the problem. The US Congress passed the Sarbanes-Oxley Act (July, 2002) - the implementation of this Act was not free from frictions - of which the major components are:

• Accounting regulation – the creation of a public accounting oversight board charged with overseeing the auditing of public companies, and restricting the consulting services that auditors can provide to clients.

• Audit committee – the company should appoint independent financial experts to its audit committee.

• Internal control assessment – public companies and their auditors should assess the effectiveness of internal control of financial record keeping and fraud prevention.

• Executive responsibility – chief executive and finance officers (CEO & CFO) must sign off the company’s quarterly and annual financial statements. If fraud causes and overstatement of earnings, these officers must return any bonuses.

The Cadbury Code (1992) – the Cadbury Committee appointed by the British government issues the Code of Best Practice in corporate governance for British companies, recommending, among other things, appointing at leas outside board directors and having the positions of CEO and board chairmen held by two different individuals.

The Dodd-Frank Act – the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 aims to identify and reduce the systematic risk of the entire financial system by regulation Wall Street and big banks.

The key features of the Dodd-Frank Act include:

• Volker rule – deposit-taking banks will be banned from proprietary trading and from owning more than a small fraction of hedge funds and private equity firms. This rule argues that banks should not be allowed to engage in casino-like activities that endanger the safety of depositors’ money.

• Resolution authority – the government can seize and dismantle a large bank in an orderly manner if the bank faces impending failure and poses a systematic risk to the broader financial system.

• Derivative securities – derivatives trading in over-the-counter markets will be transferred to electronic exchanges, with contracts settled through central clearing houses, to increase transparency and reduce counter-party risk

• Systematic risk regulation – a Financial Stability Oversight Council of government regulators chaired by the Treasury secretary will identify systematically important financial firms and monitor their activities and financial conditions.

• Consumer protection – a new, independent Consumer Financial Protection Bureau will be set up to monitor predatory mortgage loans and other loan products.