International Finance

Course Overview

Overview

Three levels to understand

1. The financial markets

2. The macroeconomy

3. The firm

The financial markets

• This is where prices are determined

• Valuation models are of two types

  • Arbitrage-free valuation
    Interest rate parity, option valuation

  • Equilibrium valuation
    Supply equals demand; International CAPM

The macroeconomy

• Competitive environment

• Exchange rate policy

• Monetary policy

• Fiscal policy

• Regulatory and legal environment

The firm

Based on market prices and the macro environment, the firm makes three decisions:

1. The investment decision

2. The financing decision

3. The risk management decision

The value of the firm

All three decisions matter because they affect firm value:

\[\text{Value of firm} = \frac{E[\text{Cash Flows}]}{\text{Required Return}}\]

Every topic in this course maps to the numerator, the denominator, or both.

Cash flow effect or discount rate effect?

When something happens in the macroeconomy or financial markets, always ask:

• Does it change expected cash flows?
  • Revenue, costs, margins, volumes, taxes, distress probability

• Does it change the required return?
  • Systematic risk, risk premia, cost of capital

• Or both?

The investment decision

Does the foreign project create value?

• Estimate expected cash flows in the relevant currency

• Determine the appropriate discount rate

• Account for country risk — but where?

  • In the cash flows? (probability-weighted scenarios)
  • In the discount rate? (risk premium)
  • Through deal structuring? (insurance, contracts)

• Compute Adjusted Present Value (APV)

The financing decision

Where and in what currency should the firm borrow?

• Home currency or foreign currency?

• At what all-in cost?

• How does the cross-currency basis affect the choice?

• Which instruments transform one type of funding into another?

  • Cross-currency swaps, interest rate swaps, FRAs

The risk management decision

Should the firm hedge, and if so, how?

• In frictionless markets, hedging is irrelevant (Modigliani-Miller)

• In practice, hedging can increase firm value by:

  • Reducing costs of financial distress
  • Reducing expected taxes
  • Reducing agency costs

• What type of exposure? Transaction, translation, operating?

• What instruments? Forwards, options, swaps, operational hedges?

The course covers the three decisions in reverse order

We start with the most concrete and build toward the most complex:

Lectures	Decision
3–4	Risk management
5	Financing
6–8	Investment

But first, Lectures 1–2 set the macro and market context:

• PPP, real exchange rates
• CIP, UIP, the basis
• FX predictability

Why reverse order?

• Risk management is the most accessible
  Concrete instruments, clear corporate problem

• Financing builds on the same instruments
  But asks a strategic question about currency and cost

• Investment is the most complex
  Requires valuation architecture, cost of capital theory, and country risk decomposition

Before the firm decides: the macro context

Lectures 1 and 2 establish why these decisions are hard:

• PPP fails → real exchange rate risk exists
  Nominal FX movements have real effects on firms

• CIP holds (mostly) → forwards are priced by arbitrage
  But the basis reveals funding stress

• UIP fails → FX risk premia exist
  Currency returns are compensation for bearing risk

If PPP, CIP, and UIP all held perfectly, international finance would be straightforward. They don’t — and that is the course.

A diagnostic for the course

Consider these four shocks:

1. Brexit — GBP depreciates 15% overnight
2. 2022 inflation shock — energy and food prices spike globally
3. Russia sanctions — Western firms lose access to Russian operations
4. CHIPS Act — US subsidizes domestic semiconductor production

For each, ask:

• Does it change expected cash flows?
• Does it change required returns?
• Does it change financing or hedging opportunities?
• Does it change the competitive or regulatory environment?

We will revisit these in Lecture 14. By then you should be able to answer precisely.

Course structure

Lecture	Topic	Decision
1	Overview, FX markets, PPP	Macro context
2	CIP, UIP, predictability, basis	Market context
3	Why hedge, measuring exposure	Risk management
4	Nonlinear exposure, FX options	Risk management
5	Swaps, FRAs, funding choice	Financing
6	Cross-border valuation, APV	Investment
7	Portfolios, ICAPM, risk premia	Investment
8	Country risk	Investment
9	Fragmentation, global risks	Application
10	Summary and integration	All