Forum-Nexus
International Finance Class –
Lecture #1
Brian David Butler
                               Brian Butler is a specialist in international economic analysis, and is
...
Introduction to International Finance
• Topics we will cover: What is “international
  finance”?
  ▫ International Financi...
Introduction to International Finance
• Topics we will cover:
  ▫   The Balance of Payments
  ▫   National Income and the ...
Key issues:
• Why is the exchange rate xxx Euros per $US?
   ▫ (PPP, IFE, other factors)
   ▫ (currency crises)


• What a...
Key issues:
• What is the Sub-prime Mortgage Crisis? And what can you do
 about it?

• How can you deal with exchange risk...
Challenge to students…
While we are in Europe together…

•   Think critically
•   Challenge accepted assumptions
•   Look ...
Questions:
Finance:
1. How many econ / finance majors?
2. Taken “international finance” before?
3. Studied Currencies?

Gl...
Failure of “economic forecasting”
profession

• Why didn’t predict worst crisis since Great
  Depression?
• Some exception...
Mis-diagnosis of the problem
• Globally, during much of 2008, economic growth appeared to
  be holding up in general, and ...
As late as 2008, the IMF forecasted
growth in 2009
Failure of “economic forecasting”
profession

Conclusion: highest trained, most respected, most
 influential did not predi...
Repeat challenge to students:

• Think critically, don’t accept “expert”
  forecasts, challenge accepted assumptions.
• Wi...
First critical thinking challenge:
• Question:
 ▫ “Why is it “expensive” to come to Europe and
   travel (shop, stay, enjo...
Global travel…

How about if you went to Argentina?
•    at about 4-1 USD…. Everything SEEMS
  cheap….hotels, restaurants,...
Question:
Why is the Euro more valuable than the US dollar?

Example: back in 2000 – dollar was more
 valuable, and it was...
Impossible to Predict

• Currencies when flexible are impossible to
  predict
 ▫ Don’t believe anyone that tells you other...
Effects…
 ▫ Effect on companies:
    Liabilities in Foreign currency – (account receivable
     1 mm euros in 6 months…wh...
Core of our class:
• Tools to protect
• Hedging techniques:
 ▫ Forward, Futures, options, etc…

 ▫ We will teach tools to ...
20




International Financial Markets

     MARKET               INSTRUMENTS         PARTICIPANTS

1. Foreign Exchange   ...
21



International Financial Markets (cont.)

       MARKET          INSTRUMENTS            PARTICIPANTS


 4. Euro-Curre...
Benefits of Global Finance
• Question for class: what are the Benefits of
  Finance? Of “GLOBALIZED” finance?
Benefits of Global Finance
1. Serve international companies
  ▫ Citi bank in Sao Paulo
  ▫ HSBC everwhere

2. Some countri...
Benefits of Global Finance
• “remember the remarkable prosperity of the past
  25 years. Finance deserves some of the cred...
Pyramid of Promises
• “Central feature of the financial system: it is a
  Pyramid of promises- often promises of long or
 ...
What “promises”?
• Financial assets represents “promises of
  future, often contingent, receipts in return for
  current p...
What “promises”?
• Life Insurance Policy
  ▫ Represent PROMISES of payment after some fixed
    date or death
• Accident /...
Pyramid of “promises”?

• “As the financial system grows more
  complex… it piles PROMISES on
  PROMISES”.




           ...
Just how big is the MOUNTAIN of
promises…?

• Amazing….




                     Martin Wolf, “Fixing Global Finance”… bas...
Size of Finance…
• Size of the Financial sector:
* data from McKinsey report 2005, "Mapping the global capital
 market" an...
Size of Finance…




                   Martin Wolf, “Fixing Global Finance”… based on McKinsey
                          ...
Size of Finance…




                   Martin Wolf, “Fixing Global Finance”… based on McKinsey
                          ...
Size of Finance…




                   Martin Wolf, “Fixing Global Finance”… based on McKinsey
                          ...
Size of Finance…




                   Martin Wolf, “Fixing Global Finance”… based on McKinsey
                          ...
“PYRAMID of Promises”

• Modern economies depend on pyramids of
  promises far more impressive and complex than
  those of...
Underneath that “PYRAMID”

• The “Foundation” of all of these PROMISES is =
  title to real assets
 ▫ Housing, land, prope...
Forum-Nexus
International Finance Class –
Lecture #2
Themes to cover today
• Review
  ▫ Key theme – borrowing in foreign currency = risky
• Foreign exchange risk management ex...
Risk - in foreign currency

• Example:
 ▫ Lets assume… you are a German company…
   buying a container of furniture from B...
Risk - in foreign currency

• Example – Brazilian furniture
  ▫ You fear that:
  ▫ What happens if the exchange rate goes ...
Avoiding Risk
 1. Don’t buy foreign goods (avoid risk)
 2. Negotiate contract so currency is based in YOUR
    currency (t...
Avoiding Risk
 1. Don’t buy foreign goods (avoid risk)
 2. Negotiate contract so currency is based in YOUR
    currency (t...
Themes to cover today
• Review
  ▫ Key theme – borrowing in foreign currency = risky
• Fragility of Banking
• Bank Busines...
Commercial Banking (business model)
• Simplified:
 ▫ Borrow short, lend long
 ▫?



• Who can explain what that means?
Borrow Short
• Deposits are LIABILITIES for banks
• They are BORROWING money from clients
• But, deposits can be withdrawn...
Lend Long
• Banks invest in Long term Assets
• Mortgages, for example… 30 years duration


• So, money is borrowed short (...
Overcoming Banking Weakness (trying)

Federal Insurance
• As a result of this inherent weakness, banks are offered
  feder...
Getting around Regulations….
Innovation
• Wherever you see regulation, you will see
  innovation (to get around the regula...
Discussion
• Law of unintended consequences
• Moral Hazard
 ▫ Ex: fire insurance… less likely to smoke?
    Health insura...
Solvency v Liquidity – QUIZ (extra
credit)
• Extra credit – 1 point in final grade

• In 20 words or less – what is a “Sol...
In addition....for those of you who have time & interest..... I am
  also sending you links to highly recommended videos
 ...
In addition....for those of you who have time & interest..... I am
  also sending you links to highly recommended videos f...
Solvent:                  not Solvent

• Ok                       NOT OK




ASSETS      Liabilities   ASSETS      Liabili...
Solvency v Liquidity
• Insolvent: liabilities > assets (equity = 0)
  ▫ Person: I owe more than Im worth
  ▫ Bank: assets ...
Solvency v Liquidity
• How does this relate to the Global Financial
  Crisis?
 ▫ discuss Solvency first:
 ▫ Then Liquidity...
Solvency v Liquidity Timeline

• 2007 – September 2008
 ▫ Mortgages (assets on Banks
   balance sheet) worth less
   than ...
Policy Response

• Question:
 ▫ If Banks have SOLVENCY
   troubles.. What should the
   government do?
 ▫ Bail out?
 ▫ Why...
Policy Response

• Key issues:
 ▫ Moral Hazard – does one
   bailout lead to future risky
   behaviour
 ▫ Fairness – is it...
Credit Crisis timeline – key dates in
September
September 7, 2008: Federal takeover of Fannie Mae and Freddie Mac[25][26]
...
Solvency v Liquidity Timeline

• September 2008 - now
 ▫ Crisis CHANGED
 ▫ No longer just a SOLVENCY CRISIS
 ▫ Became a MI...
NY times article 1999…

• Fannie Mae Eases Credit To Aid Mortgage
  Lending
 By STEVEN A. HOLMES
 Published: Thursday, Sep...
NY times article 1999…
• “The action…will encourage those banks to
  extend home mortgages to individuals whose
  credit i...
NY times article 1999…
• “Fannie Mae…has been under increasing
  pressure from the Clinton Administration to
  expand mort...
NY times article 1999…
• In addition, banks, thrift institutions and mortgage
  companies have been pressing Fannie Mae to...
NY times article 1999…
• In moving into this new area of lending, Fannie Mae
  is taking on significantly more risk, which...
NY times article 1999…
• Fannie Mae, the nation's biggest underwriter of
  home mortgages, does not lend money directly to...
Homework:
• Find 1 example of Spain & the economic crisis

• Observation ok
• News story ok

• Due – BEGINNING of next cla...
Forum-Nexus
International Finance Class –
Lecture #3 – Wednesday
SPAIN
Themes to cover Today
1. Spain & the crisis –
 ▫   Review student comments
 ▫   discuss
 ▫   quick summary (what you absol...
Spain




        http://www.economist.com/countries/Spain
Spain & the crisis –
  - Review student comments
  - discuss
  - quick summary (what you
  absolutely need to know)


• Ho...
Spain & the Crisis:
• Comment
 ▫ Each student, what is your observation?

      How has Spain been effected by the crisis...
Key points to highlight…
1. Dual structure – labor market
 ▫   Who can explain?
 ▫   Why important for crisis?

2. Dual st...
Dual Labor Market
 • Temp:
   ▫   High unemployment
   ▫   Young,
   ▫   Immigrants
   ▫   University grads
 • The rest en...
Temp workers –during the boom
 • The spread of fixed-term employment contracts in
   Spain (from the mid-1980s) helped mak...
Temp workers - crisis
 • Unfair:
  ▫ “The downturn has highlighted the gross
    unfairness of the dual labour market.
  ▫...
Spain – Banking
• “Spain’s financial sector has weathered the crisis well so
  far, thanks to strong and forward-looking p...
Cajas

   • Prediction:
   • the banking crisis will hit Spain... but not
     with the Big 2 banks of BBVA &
     Santand...
Banking troubles looming…
• “Trouble on the SMALL side: The bail-out on
  March 29th of a small savings bank, Caja Castill...
Cajas
• Spain’s cajas are mutually owned and controlled
  by a mix of depositors, employees and local
  politicians, and t...
Cajas & the crisis (housing)
• When the big two banks put the brakes on in 2006-
  07, the cajas continued lending more
  ...
Cajas & the crisis (housing)
• Mr López Díaz (analyst at Credit Suisse)
  reckons that 9% of the cajas’ total loans could
...
Cajas
                     • The pace of
                       deterioration (see
                       chart) threatens...
Cajas   • “The cajas could need €60
          billion of new equity, on
          top of the €64 billion they
          al...
Themes to cover Today
1. Spain & the crisis –
 ▫   Review student comments
 ▫   discuss
 ▫   quick summary (what you absol...
Question:


 If you were a US based bank, with dollars to invest for 12
 months…..where would you choose to deposit your m...
International Money Market       United States   England    Europe   Switzerland   Japan
Rates (Bid Side)                 ...
Interest Rate Parity

•FX market in equilibrium ONLY when interest rate parity
exists

•When deposits of all currencies of...
Market Exch Rates as of: Sept 2, 2008
 Foreign Currency                       Canada     UK*         Europe*   Switzerland...
New example…
• Team calculation…
• Form groups of 2,
• Be prepared to answer the following….
Borrowing in Foreign Currencies….
Where would you prefer to borrow?
You have a factory in Brazil, and want to borrow money...
Questions:
1. Assume you borrow R$2mm for 1 year, and
   assume exchange rate is 2:1 today…. But moves
   to 4:1
2. How mu...
Where would you prefer to borrow?

•    Local Brazil = $1.1 mm = R$2.2 mm
•    Foreign USA = $1.05 mm = R$2.1 mm
•    Diff...
Where would you prefer to borrow?
•    Local Brazil = $1.1 mm = R$2.2 mm
•    Foreign USA = $1.05 mm = R$2.1 mm
•    Diffe...
Avoiding Risk
 1. Assignment

 2. Group
     1 way of avoiding / reducing risk….
Avoiding Risk
 1. Don’t borrow in foreign currency (avoid risk)
 2. How else?
   You could…
  1. Contract with your bank ...
Forum-Nexus
International Finance Class – Lecture
#5
France - (American Business School)
– guest lecture – careers in Fina...
Financial careers
•   Commercial Banking
•   Investment Banking
•   Private Banking
•   Top US Private Banks – list & disc...
Forum-Nexus
International Finance Class –
Lecture #6
France –
Monday July 13th, 2009
Themes to cover Today
1. France –
 ▫   Discuss & review meeting notes and observation
     from the meeting @ Credit Agric...
Exam Overview 1 ½ hours
•   1 hedging problem
•   1 interest rate problem
•   5 – 10 multiple choice
•   2-3 short answer ...
To answer the essays….
• While at the OECD, ask questions to help you
  with the (extra credit) essay questions on the
  m...
Extra Credit Essays – 5 points each

1. East Europe & the Global Economic
   Crisis: many economists now talk about a
   p...
Extra Credit Essays

2. China – USA (global imbalances): In one page
   or less, explain how/ why the relationship between...
Extra Credit Essays

3. Anglo-Saxon style finance: many
   economists in main-land Europe (France,
   Germany, etc) discus...
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Forum Nexus Finance Class Lectures (Thru July 14)

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Forum Nexus Finance Class Lectures (Thru July 14)

  1. 1. Forum-Nexus International Finance Class – Lecture #1
  2. 2. Brian David Butler Brian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ (www.globotrends.com) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets. Brian earned an MBA with distinction from the Thunderbird School of Global Management and he has taught Finance, Economics and Global Trade at Thunderbird’s Global MBA program in Miami. Brian is currently a teacher and country director for Forum-Nexus brian.butler@forum-nexus.com study abroad program in Brazil. briandbutler@gmail.com LinkedIn/briandbutler He previously worked as financial analyst for the Columbia Skype: briandbutler University Business School and for NextLogics, a boutique investment and consulting firm focused on early stage endeavors with social impact. A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international schools), educated in the U.S., started his career with a Japanese company, moved to New York to work as a financial analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.
  3. 3. Introduction to International Finance • Topics we will cover: What is “international finance”? ▫ International Financial Markets ▫ The Foreign Exchange Market ▫ Determination and Forecasting of Exchange Rates  (fundamentals: purchasing power parity and international Fisher effect) ▫ Protection against Exchange Rate Risk ▫ The International Monetary System ▫ The European Monetary Union (and the euro) ▫ Fixed vs. Flexible Exchange Rate regimes
  4. 4. Introduction to International Finance • Topics we will cover: ▫ The Balance of Payments ▫ National Income and the BOP ▫ Monetary and Fiscal Policies and the BOP ▫ Global Financial Markets (euromarkets) ▫ GLOBAL ECONOMIC CRISIS
  5. 5. Key issues: • Why is the exchange rate xxx Euros per $US? ▫ (PPP, IFE, other factors) ▫ (currency crises) • What are key financial flows and why do they occur? ▫ (forex transactions; international lending; ‘hot money’ flows)
  6. 6. Key issues: • What is the Sub-prime Mortgage Crisis? And what can you do about it? • How can you deal with exchange risk? ▫ (derivatives; operational hedging; diversifying) • Who cares about the balance of payments? ▫ (impact on XR, government policies) ▫ (foreign debt problem; tequila crisis; Asia crisis) • How do national economic policies affect the BOP and international firms? ▫ (D Ms, D G)
  7. 7. Challenge to students… While we are in Europe together… • Think critically • Challenge accepted assumptions • Look for trends (not facts & figures) • Educational journey…
  8. 8. Questions: Finance: 1. How many econ / finance majors? 2. Taken “international finance” before? 3. Studied Currencies? Global Crisis: 1. How many “understand” more or less what happened so far? (ask volunteer) 2. In US? (ask volunteer) 3. In Europe? 4. Predictions of what will happen in 6 months?
  9. 9. Failure of “economic forecasting” profession • Why didn’t predict worst crisis since Great Depression? • Some exceptions (Nouriel Roubini, others..) • But, in general, a few lone voices does not equal a profession (dismissed as quack, “Dr. Doom”, etc…)
  10. 10. Mis-diagnosis of the problem • Globally, during much of 2008, economic growth appeared to be holding up in general, and inflation, particularly in commodity prices, was still rising. • IMF Projection ▫ In April 2008, eight months into the global crisis if we date its start as August 2007, the IMF (2008) was forecasting only a mild slowdown in global growth in 2008 and 2009 to 3.7 and 3.8 percent, respectively, from the 4.9 percent that then was estimated for 2007. ▫ Median consumer price inflation in the advanced countries was projected to rise to 2.9 percent in 2008 from 2.1 percent in 2007. In fact, median inflation rose to 3.2 percent. • ECB ▫ Recall that the European Central Bank (ECB) raised the target for its key refinancing rate on July 3, 2008, and the ECB was not alone in its inflation concerns at that time.
  11. 11. As late as 2008, the IMF forecasted growth in 2009
  12. 12. Failure of “economic forecasting” profession Conclusion: highest trained, most respected, most influential did not predict collapse
  13. 13. Repeat challenge to students: • Think critically, don’t accept “expert” forecasts, challenge accepted assumptions. • With critical analysis, any one can learn to spot macro trends • GET AHEAD OF THE TRENDS!!! ▫ Tools for investors ▫ Business leaders – position for threats / opportunities
  14. 14. First critical thinking challenge: • Question: ▫ “Why is it “expensive” to come to Europe and travel (shop, stay, enjoy)? ▫ Compared to US, Mexico, Brazil, etc… ▫ Why does it “seem” expensive here?
  15. 15. Global travel… How about if you went to Argentina? • at about 4-1 USD…. Everything SEEMS cheap….hotels, restaurants, clothes shopping. Watch from China = $10 • is that “cheap”? • how about if you lived in China? Is it still cheap?
  16. 16. Question: Why is the Euro more valuable than the US dollar? Example: back in 2000 – dollar was more valuable, and it was CHEAP to come to Europe. Why no more? What happened? What is happening? Note: in Sept-December 2008 (height of crisis), the Dollar appreciated v Euro…. Why?
  17. 17. Impossible to Predict • Currencies when flexible are impossible to predict ▫ Don’t believe anyone that tells you other wise ▫ Note: in this class, we will review PPP, IFE
  18. 18. Effects… ▫ Effect on companies:  Liabilities in Foreign currency – (account receivable 1 mm euros in 6 months…what will it be worth? ▫ Effect on countries:  Currency appreciates, can factories still produce?  Effect on Exporters (example Brazil 4-1 to 2-1, and exports stop)  “de-industrialization” / “Dutch-disease”
  19. 19. Core of our class: • Tools to protect • Hedging techniques: ▫ Forward, Futures, options, etc… ▫ We will teach tools to PROTECT (and potentially speculate) • But first… today- some Finance Basics…
  20. 20. 20 International Financial Markets MARKET INSTRUMENTS PARTICIPANTS 1. Foreign Exchange Deposits, Cash, Banks, Companies, Market Forwards, Futures Brokers 2. Domestic Financial T-Bills, Deposits, Banks, Companies, Markets in Other Commercial Paper, Brokers Countries—Short-Term Money Market Funds 3. Domestic Financial Bonds, Stocks, Banks, Companies, Markets in Other ADRs, Deposits, Brokers Countries—Long-Term CMOs
  21. 21. 21 International Financial Markets (cont.) MARKET INSTRUMENTS PARTICIPANTS 4. Euro-Currency Deposits, Euro CP Banks, Clients Market Euroloans 5. Euro-Bond Market Eurobonds, Floating Investment Banks Rate Notes, Companies, Brokers Euro-Equities 6. International SDRs, $US, [Gold], Central Banks, Monetary Position in the Fund The Fund System (IMF) 7. The Real Sector Goods & Services Consumers & Firms
  22. 22. Benefits of Global Finance • Question for class: what are the Benefits of Finance? Of “GLOBALIZED” finance?
  23. 23. Benefits of Global Finance 1. Serve international companies ▫ Citi bank in Sao Paulo ▫ HSBC everwhere 2. Some countries don’t have DEEP enough capital markets ▫ Needs of companies Bigger than Depth of capital markets 3. Efficiency, 4. Best practices (international competition forces local monopolies to offer better rates)
  24. 24. Benefits of Global Finance • “remember the remarkable prosperity of the past 25 years. Finance deserves some of the credit for that.” source: http://www.economist.com/printedition/displayStory.cfm?Story_ID=12957709
  25. 25. Pyramid of Promises • “Central feature of the financial system: it is a Pyramid of promises- often promises of long or even indefinite duration. This makes it remarkable that sophisticated finance systems exist” • Promises may not be kept • Interest of those who make promises NOT to keep them Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  26. 26. What “promises”? • Financial assets represents “promises of future, often contingent, receipts in return for current payments” • Bonds ▫ Represent PROMISES of fixed payment (in time), plus PROMISE of regular payments in between • Equity (stocks) ▫ Represent PROMISES a share in future corporate profits • Pensions ▫ Represent PROMISES for a stream of income in retirement Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  27. 27. What “promises”? • Life Insurance Policy ▫ Represent PROMISES of payment after some fixed date or death • Accident / Health Insurance Policy ▫ Represent PROMISES of payment if something happens • Mutual Fund ▫ Promises to return to investors the proceeds from mutual funds purchase of promises from corporations • Options ▫ Is a promise to hand over a claim to a certain promise under specific conditions Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  28. 28. Pyramid of “promises”? • “As the financial system grows more complex… it piles PROMISES on PROMISES”. Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  29. 29. Just how big is the MOUNTAIN of promises…? • Amazing…. Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  30. 30. Size of Finance… • Size of the Financial sector: * data from McKinsey report 2005, "Mapping the global capital market" and http://www.federalreserve.gov/releases/ • What is amazing is that the financial sector ballooned to the size that it has...with a worldwide total of $140 trillion in promises outstanding in 2005 (surely more in 2008/9). • Of that total, the US was the prime holder of promises (assets). The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises). Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  31. 31. Size of Finance… Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  32. 32. Size of Finance… Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  33. 33. Size of Finance… Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  34. 34. Size of Finance… Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  35. 35. “PYRAMID of Promises” • Modern economies depend on pyramids of promises far more impressive and complex than those of stone constructed almost 5 thousand years ago” • But, the system is extremely FRAGILE • Confidence that sustains them could be misplaced • People would end up with promises NOT WORTH the paper (they used to be) printed upon Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  36. 36. Underneath that “PYRAMID” • The “Foundation” of all of these PROMISES is = title to real assets ▫ Housing, land, property, factories, machines, etc ▫ Need to BELIEVE the original owner really ownes what they say they own. ▫ So, key = property rights, law, institutions – for trust, and development of financial system Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005
  37. 37. Forum-Nexus International Finance Class – Lecture #2
  38. 38. Themes to cover today • Review ▫ Key theme – borrowing in foreign currency = risky • Foreign exchange risk management example ▫ Germany importing Brazilian furniture • Fragility of Banking • Bank Business Model ▫ Borrow short, Lend long • Liquidity v Solvency ▫ Stages of crisis ▫ Money markets ▫ Transmission to Europe ▫ Paulson Plan / Geitner Plan • Moral Hazard ▫ Reserve requirements + regulation & lender of last resort ▫ Cause crisis? Make crises more likely?
  39. 39. Risk - in foreign currency • Example: ▫ Lets assume… you are a German company… buying a container of furniture from Brazil (to resell at a fixed price in Germany) ▫ You agree to pay 100,000 Reais (Brazilian currency) in 6 months to the Brazilian company for delivery ▫ Assume the currency exchange rate is currently 2:1 ▫ What is your risk?
  40. 40. Risk - in foreign currency • Example – Brazilian furniture ▫ You fear that: ▫ What happens if the exchange rate goes from 2:1 to 1:1? ▫ Instead of needing 50,000 Euros to pay that R$100,000 bill… ▫ You now need 100,000 Euros… ouch ▫ Question: how could you have avoided that risk?
  41. 41. Avoiding Risk 1. Don’t buy foreign goods (avoid risk) 2. Negotiate contract so currency is based in YOUR currency (transfer risk) 3. How else?  Guess…
  42. 42. Avoiding Risk 1. Don’t buy foreign goods (avoid risk) 2. Negotiate contract so currency is based in YOUR currency (transfer risk) 3. How else?  You could… 1. Convert your money to R$ today…and deposit that money in a Brazilian bank account (deposit hedge) 2. Contract with your bank to buy $R in 6 months at a fixed rate (2:1) for a fee (forward contract) 3. Buy a Future contract (similar) on exchange (if you can find one). 4. More… (next class)
  43. 43. Themes to cover today • Review ▫ Key theme – borrowing in foreign currency = risky • Fragility of Banking • Bank Business Model ▫ Borrow short, Lend long • Liquidity v Solvency ▫ Stages of crisis ▫ Money markets ▫ Transmission to Europe ▫ Paulson Plan / Geitner Plan • Moral Hazard ▫ Reserve requirements + regulation & lender of last resort ▫ Cause crisis? Make crises more likely?
  44. 44. Commercial Banking (business model) • Simplified: ▫ Borrow short, lend long ▫? • Who can explain what that means?
  45. 45. Borrow Short • Deposits are LIABILITIES for banks • They are BORROWING money from clients • But, deposits can be withdrawn at any time • So… their Liabilities are short term (might owe money tomorrow)
  46. 46. Lend Long • Banks invest in Long term Assets • Mortgages, for example… 30 years duration • So, money is borrowed short (term), but lent out long (term) • What is the risk? • Is this “solvency” or “liquidity” risk? (answer: Liquidity) why? (answer soon…)
  47. 47. Overcoming Banking Weakness (trying) Federal Insurance • As a result of this inherent weakness, banks are offered federal insurance for the deposits. The government is forced to federally protect (guarantee) depositors that their money will be there if they want it. Or else, people would not trust the banks, and would not deposit their money. Regulation • In exchange for this federal guarantee (that they receive), the banks (give up) are subject to stiff regulation. One of the main requirements for deposit-taking banks is that they have to maintain a certain level of money on reserve at the (Federal Reserve). In the US, this reserve requirement is 10%. http://globotrends.pbworks.com/Commercial-Banking
  48. 48. Getting around Regulations…. Innovation • Wherever you see regulation, you will see innovation (to get around the regulation). Banks are some of the most creative organizations when it comes to developing products to get around regulation. For example, there has been massive Innovation in the financial sector when it comes to the securitization of mortgages (which partly is to blame for the subprime lending crisis). http://globotrends.pbworks.com/Commercial-Banking
  49. 49. Discussion • Law of unintended consequences • Moral Hazard ▫ Ex: fire insurance… less likely to smoke?  Health insurance…. Less likely to be safe?
  50. 50. Solvency v Liquidity – QUIZ (extra credit) • Extra credit – 1 point in final grade • In 20 words or less – what is a “Solvency” problem (for banks) • In 20 words or less – what is a “Liquidity” problem (for banks) • * think of the business model • * remember the video
  51. 51. In addition....for those of you who have time & interest..... I am also sending you links to highly recommended videos from the "Khan Academy" http://www.khanacademy.org/ They are free to watch, and are an excellent way to understand the financial crisis. These additional videos are not a requirement for this course, but if you do watch them... you will really understand the economic crisis from a very advanced level.... Paulson Bailout • Bailout 1: Liquidity vs. Solvency • Bailout 2: Book Value • etc... 13 videos in series.... Geithner Plan • Geithner Plan I • Geithner Plan II • etc... 5 videos in series…
  52. 52. In addition....for those of you who have time & interest..... I am also sending you links to highly recommended videos from the "Khan Academy" http://www.khanacademy.org/ They are free to watch, and are an excellent way to understand the financial crisis. These additional videos are not a requirement for this course, but if you do watch them... you will really understand the economic crisis from a very advanced level.... Credit Crisis • The housing price conundrum • Mortgage-Backed Securities I • Collateralized Debt Obligation (CDO) • Credit Default Swaps • Wealth Destruction 1 • etc.... 15 videos in series.... Banking and Money • Banking 1 • Banking 2: A bank's income statement • Banking 3: Fractional Reserve Banking • Banking 4: Multiplier effect and the money supply • etc... more than 15 videos in series...
  53. 53. Solvent: not Solvent • Ok NOT OK ASSETS Liabilities ASSETS Liabilities -Include (Borrowi -Include (Borrowi home ng, debt) home ng, debt) mortgages mortgages -subprime -subprime Equity Equity
  54. 54. Solvency v Liquidity • Insolvent: liabilities > assets (equity = 0) ▫ Person: I owe more than Im worth ▫ Bank: assets loose value (subprime mortgages) ▫ Country: cant pay debts…default • Illiquidity: long term asset, short term liability ▫ I owe money NOW, but have money tied up in my house, car, etc… ▫ Bank: lend long term, borrow short term ▫ Country: cant access credit markets to pay imports
  55. 55. Solvency v Liquidity • How does this relate to the Global Financial Crisis? ▫ discuss Solvency first: ▫ Then Liquidity… • Examples?
  56. 56. Solvency v Liquidity Timeline • 2007 – September 2008 ▫ Mortgages (assets on Banks balance sheet) worth less than anticipated… write down ASSETS Liabilities -Include (Borrowi ▫ Hedge funds Funds go under home ng, debt)  (Bear Stearns) mortgages -subprime ▫ Bankruptcy threat Equity
  57. 57. Policy Response • Question: ▫ If Banks have SOLVENCY troubles.. What should the government do? ▫ Bail out? ▫ Why? Why not? ASSETS Liabilities -Include (Borrowi ▫ discuss home ng, debt) mortgages -subprime Equity
  58. 58. Policy Response • Key issues: ▫ Moral Hazard – does one bailout lead to future risky behaviour ▫ Fairness – is it fair to privatize gains, but socialize ASSETS Liabilities losses -Include home (Borrowi ng, debt) ▫ Risks mortgages -subprime  Systematic risks  Counter party risks Equity
  59. 59. Credit Crisis timeline – key dates in September September 7, 2008: Federal takeover of Fannie Mae and Freddie Mac[25][26] September 14, 2008: Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30] September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy. September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets. September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.
  60. 60. Solvency v Liquidity Timeline • September 2008 - now ▫ Crisis CHANGED ▫ No longer just a SOLVENCY CRISIS ▫ Became a MIXED crisis of BOTH solvency and liquidity ▫ How? Why? What does that mean? ▫ Someone tell me again…what is “liquidity”?
  61. 61. NY times article 1999… • Fannie Mae Eases Credit To Aid Mortgage Lending By STEVEN A. HOLMES Published: Thursday, September 30, 1999 • “In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.” NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A.
  62. 62. NY times article 1999… • “The action…will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A.
  63. 63. NY times article 1999… • “Fannie Mae…has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people • … and felt pressure from stock holders to maintain its phenomenal growth in profits.” NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A.
  64. 64. NY times article 1999… • In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. • These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans. NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A.
  65. 65. NY times article 1999… • In moving into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's. • ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.'' NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A.
  66. 66. NY times article 1999… • Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings. • Fannie Mae officials …add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings ... NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A.
  67. 67. Homework: • Find 1 example of Spain & the economic crisis • Observation ok • News story ok • Due – BEGINNING of next class (Tuesday) • Have a great weekend!!
  68. 68. Forum-Nexus International Finance Class – Lecture #3 – Wednesday SPAIN
  69. 69. Themes to cover Today 1. Spain & the crisis – ▫ Review student comments ▫ discuss ▫ quick summary (what you absolutely need to know) 2. Hedging Example ▫ Interest rates & Exchange rates ▫ Group assignment – in class ▫ Presentation
  70. 70. Spain http://www.economist.com/countries/Spain
  71. 71. Spain & the crisis – - Review student comments - discuss - quick summary (what you absolutely need to know) • Homework was: • “Find 1 example of Spain & the economic crisis: Observation, News story, class…
  72. 72. Spain & the Crisis: • Comment ▫ Each student, what is your observation?  How has Spain been effected by the crisis?  What have you seen?  Read?  What Questions do you have?  What risks do you see going forward?
  73. 73. Key points to highlight… 1. Dual structure – labor market ▫ Who can explain? ▫ Why important for crisis? 2. Dual structure – banking market ▫ Banks / cajas (caixas) ▫ Who can explain? ▫ Why important for crisis? ▫ EXAM material!!
  74. 74. Dual Labor Market • Temp: ▫ High unemployment ▫ Young, ▫ Immigrants ▫ University grads • The rest enjoy a high level of job protection which politicians dare not dismantle. • Risk = political backlash if crisis is LONG (if recovery takes YEARS not months) Economist.com, A special report on the euro area, Jun 11th 2009
  75. 75. Temp workers –during the boom • The spread of fixed-term employment contracts in Spain (from the mid-1980s) helped make hiring and firing more responsive to the business cycle. • Benefits: ▫ Immediate pay-off: it created jobs. ▫ Firms were content to take on temporary workers, often immigrants, because they knew they could easily lay them off again. • Growth ▫ Before the crisis hit, temporary jobs accounted for more than a third of Spain’s total, the largest share in the EU. Economist.com, A special report on the euro area, Jun 11th 2009
  76. 76. Temp workers - crisis • Unfair: ▫ “The downturn has highlighted the gross unfairness of the dual labour market. ▫ It puts the burden of adjustment on groups with no tenure (women, immigrants and the young). • Future ▫ Firms have little incentive to train tomorrow’s workforce. Instead they are stuck with older, tenured workers heading for retirement. • less than 5% are converted into permanent jobs. Economist.com, A special report on the euro area, Jun 11th 2009
  77. 77. Spain – Banking • “Spain’s financial sector has weathered the crisis well so far, thanks to strong and forward-looking prudential regulation. Dynamic loan-loss provisioning saw banks build up significant cushions during the expansion, and rigorous consolidation rules discouraged the development of off-balance sheet vehicles. And because they mainly cater to retail customers, Spain’s banks were not directly affected by U.S. subprime losses.” 1. After visiting Sabadell yesterday… 2. Everything seemed alright…right? 3. But, whats wrong? … Source: IMF “Hard Landing for Spain” IMF Survey online, April 24, 2009
  78. 78. Cajas • Prediction: • the banking crisis will hit Spain... but not with the Big 2 banks of BBVA & Santander, but rather with the many small "cajas", or regional banks that lent heavily to the construction sector The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009
  79. 79. Banking troubles looming… • “Trouble on the SMALL side: The bail-out on March 29th of a small savings bank, Caja Castilla La Mancha, could change that perception. The government’s liquidity package of up to €9 billion ($12 billion), which will probably be bolstered with equity, is a reminder that many of Spain’s bad debts fester outside the listed banks. The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009
  80. 80. Cajas • Spain’s cajas are mutually owned and controlled by a mix of depositors, employees and local politicians, and they distribute a big chunk of their profits to local causes. • Since the 1960s they have increased their market share of loans from about 10% to 50% by opening branches in smaller cities and by extending credit to people and businesses ignored by the market leaders. The Economist, “Spanish banks, The mess in La Mancha” , Apr
  81. 81. Cajas & the crisis (housing) • When the big two banks put the brakes on in 2006- 07, the cajas continued lending more keenly, tapping wholesale debt markets to fund themselves. • That alone makes them higher risk. • But the savings banks also supplied about half of the €318 billion borrowed by Spain’s property developers. These loans now represent about a fifth of the cajas’ assets, according to Santiago López Díaz, an analyst at Credit Suisse. • They are deterioratingThe Economist, “Spanish banks, The mess in La Mancha” , Apr fast.
  82. 82. Cajas & the crisis (housing) • Mr López Díaz (analyst at Credit Suisse) reckons that 9% of the cajas’ total loans could become non-performing, and within that a fifth of the loans made to property developers. The Economist, “Spanish banks, The mess in La Mancha” , Apr 2nd 2009
  83. 83. Cajas • The pace of deterioration (see chart) threatens to overwhelm the scope of reserves, capital and ongoing profits to absorb losses. The Economist, “Spanish banks, The mess in La Mancha” , Apr
  84. 84. Cajas • “The cajas could need €60 billion of new equity, on top of the €64 billion they already have. • “the government would probably be on the hook for most of it. The Economist, “Spanish banks, The mess in La Mancha” , Apr
  85. 85. Themes to cover Today 1. Spain & the crisis – ▫ Review student comments ▫ discuss ▫ quick summary (what you absolutely need to know) 2. Hedging Example 3. Interest rates & Exchange rates ▫ Group assignment – in class ▫ Presentation
  86. 86. Question: If you were a US based bank, with dollars to invest for 12 months…..where would you choose to deposit your money (to make the most return)? International Money Market United States England Europe Switzerland Japan Rates (Bid Side) dollar sterling euro franc yen Eurocurrency Rate LIBOR 12 months 3.2% 6.0% 5.3% 3.2% 1.1% Note: You can assume you have an account with a bank in London (HSBC, etc)… and its easy to switch from one account to the other (click of a button)
  87. 87. International Money Market United States England Europe Switzerland Japan Rates (Bid Side) dollar sterling euro franc yen Eurocurrency Rate LIBOR 12 months 3% 6.0% 5% 3.5% 1.1% Expected appreciation / x -3% -2% -0.5% +1.9% depreciation vs. US Dollar to EQUATE choices… Answer: it DEPENDS not just on the interest rate, but also on the expected change in foreign exchange rate as well. You might be temped to choose the England (sterling) option of 5.99% because it’s the highest…but that currency might be expected to lose value (depreciate) over the next year…wiping out the expected gains.
  88. 88. Interest Rate Parity •FX market in equilibrium ONLY when interest rate parity exists •When deposits of all currencies offer the same EXPECTED rate of return •Rate + expected (appreciation / depreciation) = rate •Example: •US / Euro. If US interest = 5%, EU = 10%, but US dollar is expected to appreciate +5% = balance Prof. Grosse, Financial Markets (p323-5)
  89. 89. Market Exch Rates as of: Sept 2, 2008 Foreign Currency Canada UK* Europe* Switzerland Japan Exchange Rates (Bid) dollar sterling euro franc yen Spot Rate— (Closing Foreign 1.0625 1.7863 1.4522 1.1090 108.84 currency units per US dollar) Forward Rate— 1 month 1.0630 1.7822 1.4498 1.1086 108.652 Closing Rates outright 3 months 1.0636 1.7749 1.4454 1.1080 108.281 outright 6 months 1.0639 1.7638 1.4391 1.1066 107.716 outright 12 months 1.0642 1.7493 1.4283 1.1043 106.453 outright *(U.S. dollars per foreign currency unit) CDN UK sterling Euro Swiss F JPN yen depreciate depreciate depreciate appreciate appreciate
  90. 90. New example… • Team calculation… • Form groups of 2, • Be prepared to answer the following….
  91. 91. Borrowing in Foreign Currencies…. Where would you prefer to borrow? You have a factory in Brazil, and want to borrow money to expand. You could… 1. Borrow money locally at 10% 2. Borrow money abroad (in US) at 5% • Which would you choose? • What is the risk of borrowing abroad (in the US)? – general comment 20 words or less Note: fictional data based on current loan rates Brazil… • LIBOR + 1.5% for US = 2.5+1.5 = 4% • CDI + 2% for Brazil = 9.75 +2 = 11.75%
  92. 92. Questions: 1. Assume you borrow R$2mm for 1 year, and assume exchange rate is 2:1 today…. But moves to 4:1 2. How much will you owe in 1 year (in local currency) ▫ Local borrow (Brazil)? ▫ Foreign borrow (US)? ▫ Compute (teams) 3. Which is better? By how much?
  93. 93. Where would you prefer to borrow? • Local Brazil = $1.1 mm = R$2.2 mm • Foreign USA = $1.05 mm = R$2.1 mm • Difference = $50,000 USD (100,000R$) • (tempting to borrow abroad ▫ But, ▫ What if FX rate goes from 2:1 to 4:1… ▫ How much will you owe (in local currency)?
  94. 94. Where would you prefer to borrow? • Local Brazil = $1.1 mm = R$2.2 mm • Foreign USA = $1.05 mm = R$2.1 mm • Difference = $50,000 USD (100,000R$) • (tempting to borrow abroad ▫ But, ▫ What if FX rate goes from 2:1 to 4:1… ▫ How much will you owe (in local currency)? ▫ Answer: ▫ Locally – still just owe R2.2mm ▫ But Foreign – would owe R4.2mm …. Double ▫ Conclusion:  Borrowing Abroad = MUCH more RISK
  95. 95. Avoiding Risk 1. Assignment 2. Group  1 way of avoiding / reducing risk….
  96. 96. Avoiding Risk 1. Don’t borrow in foreign currency (avoid risk) 2. How else?  You could… 1. Contract with your bank to buy $US in 12 months at a fixed rate (2:1) for a fee (forward contract) 2. Buy a Future contract (similar) on exchange (if you can find one). 3. More… (next class)
  97. 97. Forum-Nexus International Finance Class – Lecture #5 France - (American Business School) – guest lecture – careers in Finance
  98. 98. Financial careers • Commercial Banking • Investment Banking • Private Banking • Top US Private Banks – list & discuss • Top Global Private Banks – list & discuss
  99. 99. Forum-Nexus International Finance Class – Lecture #6 France – Monday July 13th, 2009
  100. 100. Themes to cover Today 1. France – ▫ Discuss & review meeting notes and observation from the meeting @ Credit Agricole on Saturday ▫ Observations ▫ Student comments & Discussion 2. Exam preview ▫ Preview… ▫ Extra credit essays 3. OECD meeting in the afternoon ▫ Causes / implications / current issues of the Global Economic Crisis
  101. 101. Exam Overview 1 ½ hours • 1 hedging problem • 1 interest rate problem • 5 – 10 multiple choice • 2-3 short answer (20 words or less) • (extra credit) essays * • Note: ▫ all material on exam comes from Lectures (Prof. Brian Butler), guest lectures, and from professional visits (Sabadell, Credit Agricole, Stock exchange, OECD)
  102. 102. To answer the essays…. • While at the OECD, ask questions to help you with the (extra credit) essay questions on the midterm exam: • Martin Wolf book: “Fixing Global Finance” • Internet search ▫ OECD website ▫ OECD youtube videos (search for OECD on youtube)
  103. 103. Extra Credit Essays – 5 points each 1. East Europe & the Global Economic Crisis: many economists now talk about a potential debt and currency crisis in Eastern Europe. In 1 page or less, explain what are the key issues, and which countries are involved. How does this topic relate to our class discussion of the “risks of borrowing abroad”?
  104. 104. Extra Credit Essays 2. China – USA (global imbalances): In one page or less, explain how/ why the relationship between China & USA is important to global finance, and how the “global imbalances” (Breton Woods II) is often discussed among economists as contributing to the global economic crisis. * Hint: focus on “cheap credit” from China * note: this issue is hotly debated and controversial. For a great summary, see the Martin Wolf “Fixing Global Finance” book
  105. 105. Extra Credit Essays 3. Anglo-Saxon style finance: many economists in main-land Europe (France, Germany, etc) discuss the “failure of Anglo- Saxon finance” during the global economic crisis. In 1 page or less, tell me “What do they mean”? What differences are they referring to? What changes would they recommend for the future? How do the US / UK respond to these suggestions?

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