borochkin a. a. international finance. l

International Finance

c.econ.sc.Alexander Borochkin

The EurocurrencyMarket

International Parities

Absolute PurchasingPower Parity

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InternationalPortfolio Investment

Direct ForeignInvestment

International FinanceLectures. Part 2

The EurocurrencyMarketReasons for OffshoreBankingLibor Interest RateSpreads and RiskOffshore BankingPracticesInternationalbusiness corporation(IBC)Offshore jurisdictionsOffshore companymanagement

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Contents

1. The Eurocurrency Market1.1 Reasons for Offshore Banking1.2 Libor Interest Rate Spreads and Risk1.3 Offshore Banking Practices1.4 International business corporation (IBC)1.5 Offshore jurisdictions1.6 Offshore company management

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Reasons for Offshore Banking

Offshore banking units (OBUs) make loans in theEurocurrency market when they accept deposits fromforeign banks and other OBUs.OBUs‘ activities are not restricted by local monetaryauthorities or governments, but they are prohibitedfrom accepting domestic deposits.Eurobanks enjoy lower reserve requirements, benefitfrom having no government -mandated interest ratecontrols, no deposit insurance, nogovernment-mandated credit allocations, norestrictions on entry of new banks, and low taxes.

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Libor Interest Rate Spreads and Risk

In the Eurodollar market, loan interest rates areusually quoted as percentage points above LIBOR(Intercontinental Exchange London Interbank OfferedRate).LIBOR is a benchmark rate that some of the world’sleading banks charge each other for short-term loans.There are a total of 150 Libor rates posted each day;interest rates are compiled for loans with 15 differentmaturities for each of 10 major currencies.The most commonly quoted rate is the three-monthU.S. dollar rate

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Libor rates set the basis for a range of financialinstruments such as

home mortgages;corporate loans;credit card interest rates.

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Offshore Banking Practices

Eurobanks are not able to create money as banks canin a domestic setting.Eurobanks are essentially intermediaries; they acceptdeposits and then loan these deposits.Like all intermediaries, Eurobanks tend to borrowshort term and lend long term.

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To open offshore bank account

All reputable banks will ask for a very detailed personal andbusiness information from the owners and controllers of theoffshore bank account.Bank will need to identify the actual beneficial owner(s) ofthe underlying offshore company.Documents: a certified passport copy, a bankers reference, adetailed business description and a cashflow forecast.(documentary requirements may vary from bank to bank.)Private information will remain strongly protected by thebanking secrecy laws.Offshore financial centrers: Switzerland, Austria, HongKong, Cayman Islands, Isle of Man some countries ofEastern and Central Europe

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Offshore company or offshore corporation

The term offshore company or offshore corporation is usedin at least two distinct and different ways. An offshorecompany may be a reference to:

a corporation or (sometimes) other type of legalentity which is incorporated or registered in anoffshore financial centre or “tax haven”;a company or corporate group (or sometimes adivision thereof) which engages in offshoringmanufacturing or business services.

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Offshore company or offshore corporation

The term offshore company or offshore corporation is usedin at least two distinct and different ways. An offshorecompany may be a reference to:

a corporation or (sometimes) other type of legalentity which is incorporated or registered in anoffshore financial centre or “tax haven”;a company or corporate group (or sometimes adivision thereof) which engages in offshoringmanufacturing or business services.

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International business corporation (IBC)

An international business companyor international business corporation (IBC)

is an offshore company formed under the laws of somejurisdictions as a tax neutral company which is usuallylimited in terms of the activities it may conduct in, butnot necessarily from, the jurisdiction in which it isincorporated.

An offshore company is a flexible business tool and assuch can be integrated into a wide variety of tax planningand asset protection arrangements.

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The main applications of offshore companies

Trading CompanyProfessional Service CompanyInvestment CompanyRoyalty / Copyright / Patent Holding CompanyShipping CompanyHolding and Property Owning Companies

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Holding and Property Owning CompaniesMore details

Used for holding shares of subsidiaries located in hightax countries;A high net worth individual with properties or otherassets in a number of countries may wish to holdthese through the medium of a personal holdingcompany (protection against inheritance tax andhigher rates of taxation, saves legal fees and avoidspublicity);investment in overseas property (holiday villas). Saleof the property is the sale of the company shares tothe purchaser;fully or nearly tax-free repatriation of offshore tradingprofits directly to the beneficial owner of thecompanies.

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Structure of an offshore company I

Registered Address.The formal reason of thisaddress is to have an exact location of the companyfor the purpose of official correspondence or inquiriesfrom the government.Registered Agent to have some person (or, usually,a professional services firm) who acts as an“intermediary” linking the government and theparticular offshore company. The name and addressof the Registered Agent are on public file in theRegistrar of Companies, so this information isaccessible to anyone who needs to ask.

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Structure of an offshore company I

Registered Address.The formal reason of thisaddress is to have an exact location of the companyfor the purpose of official correspondence or inquiriesfrom the government.Registered Agent to have some person (or, usually,a professional services firm) who acts as an“intermediary” linking the government and theparticular offshore company. The name and addressof the Registered Agent are on public file in theRegistrar of Companies, so this information isaccessible to anyone who needs to ask.

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Structure of an offshore company II

Memorandum of Association and Articles ofAssociation to describe the type of company, its address,operational objects and similar administrative matters thatare characteristic to any corporate entity.The Memorandum and Articles of an offshore company areusually signed by a person called “Subscriber” or“Incorporator” (a person or, more often, a dedicated offshoreservices firm closely associated with offshore serviceprovider).First Minutes contains information about the name,registered address and registration number of the company,establishes the secretary (registered agent), first directorand how the company shares are being allocated to theshareholders.

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Offshore jurisdictions

Classic tax haven countries such as Bermuda, BritishVirgin Islands and the Cayman Islands.Small intermediate countries such as Hong Kong andSingapore (sometimes referred to as "mid-shore"jurisdictions) which, whilst having oversized financialcentres, are not zero tax regimes.Industrialised economies which can be used as part oftax mitigation structures: Ireland, the Netherlandsthe United Kingdom.In Federal systems, states can operate like a classicoffshore centers: Delaware in the United States.

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Main offshore financial centres and tax havens

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Main offshore financial centres and tax havens I

Bahamas, which has a considerable number ofregistered vessels. The Bahamas used to be thedominant force in the offshore financial world, but fellfrom favour in the 1970s after independence.

Bermuda, which is market leader for captiveinsurance, and also has a strong presence in offshorefunds and aircraft registration.

British Virgin Islands, which has the largest numberof offshore companies.

Cayman Islands, which has the largest value of assetsunder management in offshore funds, and is also thestrongest presence in the U.S. securitisation market.

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Main offshore financial centres and tax havens II

Jersey has particularly strong banking and fundsmanagement sectors and a high concentration ofprofessional advisers including lawyers and fundmanagers.

Luxembourg, which is the market leader inUndertakings for Collective Investments inTransferable Securities (UCITS).

Mauritius is used for both inward and outwardinvestment platform for Asian, African and Europeancountries, it has the effective commercial and legalinfrastructure required to support the development ofa global network.

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Main offshore financial centres and tax havensIII

Panama, which is a significant international maritimecentre. Although Panama (with Bermuda) was one ofthe earliest offshore corporate domiciles, Panama lostsignificance in the early 1990s.

New Zealand, the remotest jurisdiction, has theadvantage of being a true primary jurisdiction butwith a tough but practical regulatory regime. It iswell positioned for the Asian market but retains closeties to Europe.

Dominica, which has the largest number of offshorecompanies formed in recent years. In recent years isnow becoming a major financial center for offshorebanks.

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Main offshore financial centres and tax havensIV

Switzerland: taxes in Switzerland are levied by theSwiss Confederation, the cantons and themunicipalities. Switzerland is sometimes considered atax haven due to its general low rate of taxation, itspolitical stability as well as the various taxexemptions or reductions available to Swisscompanies doing business abroad, or foreign personsresiding in Switzerland.

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The world‘s five leading offshore finance centres

JerseyGuernseyIsle of ManBermuda HamiltonCayman Islands

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Offshore company management I

Option 1: Company directed by the beneficial owner.Option 2: Company directed by an appointedDirector (nominee).

The owner of an offshore IBC may often be reluctant topublicly reveal his controlling position over a particularoffshore company.If these considerations are important, the owner of theIBC, or any related individual who may be concerned withthe same potential risks, should not be appointed to adirect managerial position of the offshore company. In thiscase, Company Management services (nominee services)should be chosen.

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Offshore company management I

Option 1: Company directed by the beneficial owner.Option 2: Company directed by an appointedDirector (nominee).

The owner of an offshore IBC may often be reluctant topublicly reveal his controlling position over a particularoffshore company.If these considerations are important, the owner of theIBC, or any related individual who may be concerned withthe same potential risks, should not be appointed to adirect managerial position of the offshore company. In thiscase, Company Management services (nominee services)should be chosen.

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Offshore company management II

A professional Director “rents out” his name (“NomineeDirector”).The owner may be formally appointed as the"representative" or "agent" of his IBC and sing himself allcontracts, invoices and business correspondence.An active direct management of an IBC by the beneficialowner greatly reduces his level of personal secrecy in thisrespect (personal tax consequences for the owner).Comprehensive company management services provided by athird-party Director largely resolve the foreign taxation issue.Nominee shareholders. The professional service relationshipbetween a Nominee Shareholder and the actual owner of theoffshore company would usually be confirmed by a TrustDeclaration

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Business activities requiring special license

Trading in Foreign Exchange (Forex, FX)Trading in financial commodity-based derivative instrumentsand other securities (futures, options, interest rates, shares,stock, contracts for differences etc.)Money transmission servicesPayment processing servicesMoney brokeringMoney lending and pawningMoney exchangeBrokerage, consultancy and advisory services in any financialservicesAccounting servicesSafe custody servicesInternational asset protection and management

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Benefits for registering financial servicescompany in offshore

Tax exemption.Simple licensing requirements.Low level of regulations and simple documentaryrequirementsno obligation of financial reporting which allows thecompany to avoid complicated and expensiveaccountancy organization.The only exception is the obligation to keep theminimum capital paid and unimpaired at all times.

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The minimum paid-up capital requirements forfinancial services companies

Trading in Foreign Exchange (Forex, FX) and otherfinancial instruments (futures, options, interest rates,shares, stock, contracts for differences etc.) –USD 100 000.Money exchange – USD 75 000.Money transmission and payment processing services,money brokering, money lending and pawning –USD 50 000.Brokerage, consultancy and advisory services, safecustody services, accounting services, internationalasset protection and management – USD 25 000.

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The European Union withholding tax

The European Union made a large number of offshorefinancial centres sign up to the European Unionwithholding tax.Under those regulations, brought into force by local law,banks in those jurisdictions which hold accounts for EUresident nationals must either deduct a 15% withholdingtax (which is split between the offshore jurisdiction andthe country of the account holder‘s residence), or permitfull exchange of information with the country of thenational‘s residence.A number of larger jurisdictions, including Hong Kong andSingapore, refused to sign up to the directive.

International ParitiesInterest Parity.Interest Rates andInflationThe relation betweenExchange Rates,Interest Rates, andInflation

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Contents

2. International Parities2.1 Interest Parity. Interest Rates and Inflation2.2 The relation between Exchange Rates, Interest Rates,

and Inflation

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Interest ParityInterest Rates and Inflation

Interest rate parity is a no-arbitrage condition on themarket under which investors will be indifferent tointerest rates available on bank deposits in twodifferent currencies.No-arbitrage condition exists when the market pricesdo not allow for profitable arbitrage.This condition does not always hold and this createpotential opportunities for riskless profits fromarbitrage deals.Two assumptions central to interest rate parity arecapital mobility and perfect substitutability ofdomestic and foreign assets.

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Two forms of interest rate parities

uncovered interest rate parity (UIRP) exists whenexposure to foreign exchange risk is uninhibited;covered interest rate parity (CIRP) exists when aforward contract has been used to cover exchangerate risk

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Two forms of interest rate parities

uncovered interest rate parity (UIRP) exists whenexposure to foreign exchange risk is uninhibited;covered interest rate parity (CIRP) exists when aforward contract has been used to cover exchangerate risk

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Uncovered interest rate parity (UIRP)

1 + iUSD =EtSt+k

St(1 + iEUR), (1)

where EtSt+k is the expected future spot exchange rate attime t + k ;k is the number of periods into the future from time t;St is the current spot exchange rate at time t;iUSD , iEUR are the interest rates in the domestic andforeign currencies, for example USD and EUR respectively.The dollar return on dollar deposits, 1 + iUSD , is shown tobe equal to the dollar return on euro deposits,EtSt+k

St(1 + iEUR).

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Covered interest rate parity (CIRP)

1 + iUSD =FtSt

(1 + iEUR) or

iUSD − iEUR =Ft − St

whereFt is the forward exchange rate at time t;The dollar return on dollar deposits, 1 + iUSD , is shown tobe equal to the dollar return on euro deposits,FtSt

(1 + iEUR).Covered interest arbitrage is an arbitrage trading strategywhereby an investor capitalizes on the interest ratedifferential between two countries by using a forwardcontract to cover exchange rate risk.

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The relation between Exchange Rates, InterestRates, and Inflation

The nominal interest rate is the rate actuallyobserved in the market.The real rate is a concept that measures the returnafter adjusting for inflation.

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The relation between Exchange Rates, InterestRates, and Inflation

The nominal interest rate is the rate actuallyobserved in the market.The real rate is a concept that measures the returnafter adjusting for inflation.

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The Fisher effect

iUSD = rUSD + pUSD (3)

iEUR = rEUR + pEUR (4)

wherei is the nominal interest rate;r is the real interest rate;pUSD is the expected rate of inflation (in this case in USdollars or EUR).

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Real interest rate parity (RIRP)

UIRP : ∆EtSt+k = EtSt+k − St

= iUSD − iEUR , (5)

EtSt+k = ∆Et(pUSDt+k ) − ∆Et(p

EURt+k ), (6)

wherepUSDt+k , pEURt+k represent expected rate of inflation for bothcurrencies respectively (dollar and Euro in this example).If the above conditions hold, then they can be combinedand rearranged as the following:

RIRP : iUSD − ∆Et(pUSDt+k ) = iEUR − ∆Et(p

EURt+k ), (7)

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The link between interest rates, inflation, andexchange rates

RIRP : iUSD − iEUR = pUSDt+k − pEURt+k

=Ft − St

St. (8)

The interest differential is equal to expected rates ofinflation differential and is also equal to the forwardpremium.The parity condition suggests that real interest rates willequalize between countries and that capital mobility willresult in capital flows that eliminate opportunities forarbitrage.

Absolute PurchasingPower ParityThe Big Mac IndexRelative PurchasingPower ParityOvervalued andUndervaluedCurrenciesReal Exchange Rates

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Contents

3. Absolute Purchasing Power Parity3.1 The Big Mac Index3.2 Relative Purchasing Power Parity3.3 Overvalued and Undervalued Currencies3.4 Real Exchange Rates

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Absolute Purchasing Power Parity (PPP)

whereE is the spot exchange rate (domestic currency units perforeign unit);P the domestic price index;PF the foreign price index.P and PF may be thought of as consumer price indexes orproducer price indexes.Absolute PPP indicates that the exchange rate betweenany two currencies is equal to the ratio of their priceindexes.

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The Big Mac Index

is published by The Economist(http://www.economist.com) as an informal way ofmeasuring the purchasing power parity (PPP) betweentwo currencies and provides a test of the extent to whichmarket exchange rates result in goods costing the same indifferent countries.

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The Big Mac index

Sources: McDonald‘s,The Economist. 2016.

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Relative Purchasing Power Parity

∆E = ∆P − ∆PF , (10)

where ∆E is equal to the percentage change in thedomestic price level (∆P) minus the percentage change inthe foreign price level (∆PF ).Absolute PPP states that the exchange rate is equal tothe ratio of the price indexes, relative PPP deals withpercentage changes in these variables.If absolute PPP holds, then relative PPP will also hold.But if absolute PPP does not hold, relative PPP still may.This is so because the level of E may not equal P

PF , butthe change in E could still equal the inflation differential.

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Overvalued and Undervalued Currencies

Overvalued and Undervalued Currencies definition

If, over time, foreign price index rises faster thandomestic price index, then we would expect spot exchangerate, the domestic currency price of the foreign currency,to fall. If E does not fall by the amount suggested by thelower P

PF , then the domestic currency is undervalued or(the same thing) that the foreign currency is overvalued.

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The implied PPP exchange rate

The implied PPP exchange rate measures the valuesthe exchange rate would take if the percentagechange in the exchange rate equaled the inflationdifferential between two countries.If the spot exchange rate is greater than the impliedPPP exchange rate than the currency is supposed tobe overvalued. Otherwise, the currency would beundervalued.

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The implied PPP exchange rate

The implied PPP exchange rate measures the valuesthe exchange rate would take if the percentagechange in the exchange rate equaled the inflationdifferential between two countries.If the spot exchange rate is greater than the impliedPPP exchange rate than the currency is supposed tobe overvalued. Otherwise, the currency would beundervalued.

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Real Exchange Rates

The real interest rate is the rate of interest isexpected rate to receive after adjustment for inflation.The real exchange rate is the purchasing power of acurrency relative to another at current exchange ratesand prices.

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Real Exchange Rates

The real interest rate is the rate of interest isexpected rate to receive after adjustment for inflation.The real exchange rate is the purchasing power of acurrency relative to another at current exchange ratesand prices.

Forex forecastingTypes of ForeignExchange RiskForeign ExchangeRisk PremiumForeign ExchangeForecasting

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Contents

4. Forex forecasting4.1 Types of Foreign Exchange Risk4.2 Foreign Exchange Risk Premium4.3 Foreign Exchange Forecasting

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Types of Foreign Exchange Risk

1. Translation exposure.2. Transaction exposure.3. Economic exposure.

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Translation exposure

This is also known as accounting exposure. It is thedifference between foreign currency denominated assetsand foreign currency denominated liabilities.

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Transaction exposure

This is exposure resulting from the uncertain domesticcurrency value of a foreign currency denominatedtransaction to be completed at some future date.

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Economic exposure

This is exposure of the firm’s value to changes inexchange rates. If the value of the firm is measured as thepresent value of future after-tax cash flows, then economicexposure is concerned with the sensitivity of the realdomestic currency value of long-term cash flows toexchange rate changes.

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Foreign exchange risk may be hedged oreliminated by the following strategies

Trading in forward, futures, or options markets.Invoicing in the domestic currency.Speeding (slowing) payments of currencies expectedto appreciate (depreciate).Speeding (slowing) collection of currencies expectedto depreciate (appreciate).

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Foreign Exchange Risk Premium

The forward exchange rate may serve as a predictorof future spot exchange rates. We may questionwhether the forward rate should be equal to theexpected future spot rate.The effective return differential is equal to thepercentage difference between the forward andexpected future spot exchange rate.

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Foreign Exchange Risk Premium

The forward exchange rate may serve as a predictorof future spot exchange rates. We may questionwhether the forward rate should be equal to theexpected future spot rate.The effective return differential is equal to thepercentage difference between the forward andexpected future spot exchange rate.

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The effective return differential

iUSD − E ∗t+1 − iEUR = (F − E ∗

t+1)/Et , (11)

whereiUSD , iEUR are interest rates on US dollar and Eurorespectively;E ∗t+1 is the expected dollar price of EUR next period;

Et is the current spot exchange rate;F is the forward exchange rate.E ∗t+1 may be interpreted as the price of future contract on

the same currency pair that the forward exchange rate isconsidered.

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The risk premium in the forward exchangemarket

F − E ∗t+1

Et(12)

If the effective return differential is zero, then there wouldappear to be no risk premium. If the effective returndifferential is positive, then there is a positive riskpremium on the domestic currency.

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Foreign Exchange Forecasting

A fundamental model forecasts exchange rates basedon variables that are believed to be importantdeterminants of exchange rates.A technical trading model uses the past history ofexchange rates to predict future movements.Technical traders use charts or diagrams depictingthe time path of an exchange rate which they believewill reverse or accelerate the trend.

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Foreign Exchange Forecasting

A fundamental model forecasts exchange rates basedon variables that are believed to be importantdeterminants of exchange rates.A technical trading model uses the past history ofexchange rates to predict future movements.Technical traders use charts or diagrams depictingthe time path of an exchange rate which they believewill reverse or accelerate the trend.

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MultinationalsFinancial ControlCash ManagementLetters of CreditIntrafirm TransfersCapital Budgeting

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Contents

5. Multinationals5.1 Financial Control5.2 Cash Management5.3 Letters of Credit5.4 Intrafirm Transfers5.5 Capital Budgeting

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Financial Control

The multinational firms carry currency exchange riskand some other risks in which domestic companiesmay never have been involved.Typical control systems are based on settingstandards with regard to sales, profits, inventory, orother specific variables and then examining financialstatements and reports to evaluate the achievementof such goals.

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Financial Control

The multinational firms carry currency exchange riskand some other risks in which domestic companiesmay never have been involved.Typical control systems are based on settingstandards with regard to sales, profits, inventory, orother specific variables and then examining financialstatements and reports to evaluate the achievementof such goals.

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Cash Management

Cash management involves using the firm’s cash asefficiently as possible.Cash is the most liquid asset. Since cash earns nointerest, the firm has a strong incentive to minimizeits holdings of cash.

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Cash Management

Cash management involves using the firm’s cash asefficiently as possible.Cash is the most liquid asset. Since cash earns nointerest, the firm has a strong incentive to minimizeits holdings of cash.

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Multinational cash management

Centralization of cash managementNetting

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Multinational cash management

Centralization of cash managementNetting

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Letters of Credit

A letter of credit (LOC)

is a written instrument issued by a bank at the requestof an importer that obligates the bank to pay a specificamount of money to an exporter.

Following condition are specified in the contract:payment time;documents to be presented by the exporter prior topayment;a bill of lading (a detailed list of the content that isshipped, and can be used to identify missing ordamaged items).

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Intrafirm Transfers

The price that one subsidiary charges anothersubsidiary for internal goods transfers is called atransfer price.The transfer prices can be a sensitive internalcorporate issue because it helps to determine howtotal firm profits are allocated across divisions.Governments are also interested in transfer pricingsince the prices at which goods are transferred willdetermine tariff and tax revenues.The parent firm always has an incentive to minimizetaxes by pricing transfers in order to keep profits lowin high-tax countries and by shifting profits tosubsidiaries in low-tax countries.

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Intrafirm Transfers

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Intrafirm Transfers

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Intrafirm Transfers

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Capital Budgeting

Capital budgeting refers to the evaluation ofprospective investment alternatives and thecommitment of funds to preferred projects.Long-term commitments of funds extending beyondone year are called capital expendituresForeign projects involve foreign exchange risk,political risk, and foreign tax regulations.Several effects should be included in project valuation

depreciation charges;credit terms extended to the subsidiary by agovernment orofficial agency;deferred or reduced taxes given as incentive toundertake the expenditure.

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Capital Budgeting

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Capital Budgeting

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Capital Budgeting

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Capital Budgeting

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Capital Budgeting

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InternationalPortfolio InvestmentPortfolioDiversificationDepositary receiptsThe Globalization ofEquity Markets

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Contents

6. International Portfolio Investment6.1 Portfolio Diversification6.2 Depositary receipts6.3 The Globalization of Equity Markets

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Portfolio Diversification

Diversification means reducing non-systematic risk byinvesting in a variety of assets.The variance that can be eliminated throughdiversification is called nonsystematic risk; this is therisk that is unique to a particular firm or industry.Systematic risk is common to all firms and remainseven in diversified portfolios.International diversification:

More wide than domestic.By investing across countries, we eliminate partof the cyclical fluctuation in our portfolio thatwould arise from the domestic business cycle.

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Depositary receipts

A depositary receipt is a negotiable financialinstrument issued by a bank to represent a foreigncompany’s publicly traded securities.When the depositary bank is in the U.S., theinstruments are known as American DepositaryReceipts (ADRs). European banks issue Europeandepository receipts (EDRs), and other banks issueglobal depository receipts (GDRs).

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Depositary receipts

A depositary receipt is a negotiable financialinstrument issued by a bank to represent a foreigncompany’s publicly traded securities.When the depositary bank is in the U.S., theinstruments are known as American DepositaryReceipts (ADRs). European banks issue Europeandepository receipts (EDRs), and other banks issueglobal depository receipts (GDRs).

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The Globalization of Equity Markets

A segmented market is one in which foreign investorsare not allowed to buy domestic stocks and domesticinvestors are not allowed to buy foreign stocks.Part of the process of the globalization of worldeconomies is the liberalization of stock marketrestrictions to open markets to the world.

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The Globalization of Equity Markets

A segmented market is one in which foreign investorsare not allowed to buy domestic stocks and domesticinvestors are not allowed to buy foreign stocks.Part of the process of the globalization of worldeconomies is the liberalization of stock marketrestrictions to open markets to the world.

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Emerging economies have the following signs I

Attempting to order its national accounts, privatizestate companies, and deregulate economic activity.

Stabilizing its political system, moving from moreautocratic regimes to liberal, democratic rules;

increasing public interest in solving the most pressingsocial problems.

Rapidly dismantling the barriers to foreign trade andinvestment, thereby quickly increasing its share in theworld economy.

Being flooded by foreign capital, hard technologies,and new, advanced managerial practices, asmultinational corporations (MNCs) enter its territory.

Forex forecasting

Multinationals

60/ 68

Emerging economies have the following signs II

Experiencing a profound change in the structure ofentire industries and individual companies, pushingfirms to approach international standards ofcompetitiveness.

Growing rate of activity in mergers and acquisitions(M8cAs), joint ventures, and the establishment ofwholly owned subsidiaries to extract value from theproductivity gaps existing between the emergingeconomy and other more developed markets.

Boasting domestic stock market, which beckonsinternational financial investors.

Expanding influence to other neighboring economies,which, in turn, start to open to the world.

Forex forecasting

Multinationals

Direct ForeignInvestmentDirect ForeignInvestmentCapital FlightInternationalLending and CrisisIMF ConditionalityCountry RiskAnalysis

61/ 68

Contents

7. Direct Foreign Investment7.1 Direct Foreign Investment7.2 Capital Flight7.3 International Lending and Crisis7.4 IMF Conditionality7.5 Country Risk Analysis

Forex forecasting

Multinationals

61/ 68

Direct Foreign Investment

Direct foreign investment is the spending by adomestic firm to establish foreign operating units.In the balance of payments, direct investment isdistinguished from portfolio investment solely on thebasis of percentage of ownership.Capital flows are designated as direct investmentwhen a foreign entity owns 10 percent or more of afirm.

Forex forecasting

Multinationals

61/ 68

Forex forecasting

Multinationals

61/ 68

Forex forecasting

Multinationals

62/ 68

Direct investment in Russian Federationin millions of US dollars for years 1994 - 1Q2014

Source: Central Bank of Russian Federation, www.cbr.ru.2014

Forex forecasting

Multinationals

63/ 68

Capital Flight

When the risk of doing business in a country rises sharply orthe expected return falls, there are probable large outflowsof investment funds so that the country experiences massivecapital account deficits.The change in the risk-return relationship that gives rise tocapital flight may be the result of political or financial crisis,tightening capital controls, tax increases, or fear of adomestic currency devaluation.On the other side, a large capital inflow in a short period oftime can lead to an appreciation of the recipient country’scurrency. This appreciation may reduce the competitivenessof the nation’s export industries and cause a fall in outputand rise in unemployment in these industries.

Forex forecasting

Multinationals

63/ 68

Capital Flight

Forex forecasting

Multinationals

63/ 68

Capital Flight

Forex forecasting

Multinationals

64/ 68

International Lending and Crisis

Warning indicators of potential future crises:Fixed exchange rates.Falling international reserves.Lack of transparency.

Forex forecasting

Multinationals

64/ 68

Forex forecasting

Multinationals

64/ 68

Forex forecasting

Multinationals

65/ 68

IMF Conditionality

The IMF not only “bail out” commercial bank orgovernment creditors.The IMF requires borrowers to adjust their economicpolicies to reduce balance of payments.The IMF has been criticized for imposing conditionsthat restrict economic growth and lower livingstandards in borrowing countries.The typical conditionality involves reducinggovernment spending, raising taxes, and restrictingmoney growth.

Forex forecasting

Multinationals

65/ 68

IMF Conditionality

Forex forecasting

Multinationals

65/ 68

IMF Conditionality

Forex forecasting

Multinationals

65/ 68

IMF Conditionality

Forex forecasting

Multinationals

66/ 68

Country Risk Analysis

The evaluation of the overall political and financialsituation in a country and the extent to which theseconditions may affect the country’s ability to repay itsdebts.There are qualitative and quantitative factors thataffect country risk premium

Forex forecasting

Multinationals

66/ 68

Country Risk Analysis

The evaluation of the overall political and financialsituation in a country and the extent to which theseconditions may affect the country’s ability to repay itsdebts.There are qualitative and quantitative factors thataffect country risk premium

Forex forecasting

Multinationals

67/ 68

Qualitative factors that affect country riskpremium

1. Splits between different language, ethnic, and religiousgroups that threaten to undermine stability.2. Extreme nationalism and aversion to foreigners thatmay lead to preferential treatment of local interests andnationalization of foreign holdings.3. Unfavorable social conditions, including extremes ofwealth.4. Conflicts in society evidenced by frequency ofdemonstrations, violence, and guerrilla war.5. The strength and organization of radical groups.

Forex forecasting

Multinationals

68/ 68

Quantitative factors that affect country riskpremium

1. External debt.2. International reserve holdings.3. Exports.4. Economic growth.