London School of Economics and Political Science Department of Finance

FM472

INTERNATIONAL FINANCE Course content, information and guide to readings

Further information on http://moodle.lse.ac.uk/

Dr Elisabetta Bertero
Lent Term 2014

Lectures
Tuesdays 11-13 Room CML.2.02

Administrative support
Ms Brenda Clarkson-Williams (B.Clarkson-Williams@lse.ac.uk)

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Content and objectives of the course

This course uses exchange rates as a unifying theme to present a number of International Finance topics, some relevant for understanding the recent global financial turmoil. The course is divided into four parts, each looking at exchange rates from a different perspective: (i) theory: theory of exchange rate determination; (ii) government policy: exchange rates as policy tool, choice of exchange rate regime and international coordination; (iii) global systemic risk: exchange rates and financial crises; (iv) risk management of firms and investors: measurement and hedging exchange rate risk. The course takes a broad perspective and includes topics in Macro-finance, International Macroeconomics, International Monetary Economics, Political Economy, and International Financial Management. It addresses both theoretical developments and related empirical evidence. The field of International Finance has been in constant evolution during recent decades and even more so during the recent financial crises. The fast-paced developments - the globalisation of capital flows, the transmission of financial crises, the integration of financial markets, the introduction of the Euro, the development of new international financial instruments, the global imbalances in current accounts and related reserve accumulation, the threat of currency wars and protectionism, the European sovereign debt crisis, the effects of the unprecedented tapering of US quantitative easing make this a challenging empirical and theoretical field of study, for which a broader and more interdisciplinary perspective is necessary. In this course, therefore, much consideration is given also to government policies and institutional and regulatory structures in different countries. An important and integral part of the course is the group research project. This year this consists of a country case study on the international spillovers of the recent unconventional monetary policies of advanced economies (details in separate handout). By the end of the course students should have acquired: an understanding of the seminal research and concepts in international finance; an idea of the direction of current research in this area; an exposure to some technical aspects of the field; a familiarity with current international finance developments.

Readings, study pack and handouts

For each topic, the readings are divided into: Required readings, which are selected sections of journal articles. The papers are marked with a star (*) in the reading list and are collected in a study pack available to students registered for this course. An from the Department of Finance Student Information Centre (OLD 3.06) after the second lecture (Jan 22nd, 2014) Textbook readings, which are selected chapters from Keith Pilbeam (2013), International Finance, Palgrave, 4th edition. These are also essential readings for the course; they provide the background for the various topics and the context for the journal articles. Further readings, which are journal articles and books for those who want to explore the topics beyond the lecture material. These are optional. They are available through the LSE Electronic Library accessible through the block on the bottom left hand side of FM472 Moodle page.

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Other useful textbooks are (specific sections are recommended for individual topics in the lecture
handouts):

C. Eun and B. Resnick (2012) , International Financial Management, 6th edition; P. Krugman, M. Obstfeld and M. Melitz (2012), International Economics, Pearson, 9th, parts 3 and 4; R. Lyons (2001) The microstructure approach to exchange rates, MIT Press; Shapiro, A. (2010) Multinational Financial Management, 9th edition, London, FT Prentice Hall Sercu, P. and R. Uppal (1995) International Financial Markets and the Firm, Chapman and Hall C. P. Hallwood and R. MacDonald (2000) International Money and Finance, Blackwell, 3rd edition; L. Copeland (2008) , Exchange Rates and International Finance, FT-Prentice Hall, 5th edition; M. Obstfeld and K. Rogoff (1996) Foundations of International Macroeconomics, MIT Press; Heffernan, S. and P. Sinclair (1990) Modern International Economics, Oxford, Basil Blackwell; Levi, M. (2005) International Finance, 4th Edition, McGraw-Hill.

Required group research project

The group essay on a different topic every year is an integral component of this course. All students signed up for this course are required to participate fully. A separate handout and detailed instructions for this project will be discussed during the first class. It is therefore essential that all students, whether already registered for the course or still undecided, attend the first FM472 class on Friday, 17th January 2014.

Weekly classes
The one-hour weekly classes for smaller groups cover numerical applications and discussions of concepts taught in the lectures as well as related new material. Some guidelines to solutions for numerical questions are available in hard copy from the Department of Finance Student Information Centre (OLD 3.06) from the Monday after the relevant class. There are no solutions for essay-type questions. Attendance is therefore essential to prepare for the exam. The exam is based on the material taught in both lectures and classes. Students are expected to prepare the assignments in advance and to come to class ready to discuss their answers. Students must attend the class at the time they signed up for in their LseForYou timetable. Attendance is recorded.

Handouts and Moodle

Handouts of the Power Point slides presented in the lectures are distributed at the beginning of each lecture. Handouts with class exercises are distributed at the beginning of the previous class. These handouts and other material for this course are available on Moodle. Students registered for this course are automatically enrolled in its Moodle pages. Announcements, notifications and other relevant information will be sent through Moodle or to LSE email addresses. Students are reminded to check their LSE email box daily.

Examination
This course is 100% exam assessed in May/June with a two-hour written examination, which includes both essay-type and numerical questions. Past exam papers are accessible through the LSE Library website (on FM472 Moodle webpage, bottom-left box).
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COURSE CONTENTS AND READINGS

1. INTRODUCTION
Motivation for the course and required readings for the group research project

Required reading for first class and for group research project (ESSENTIAL READINGS for project - distributed during first lecture and available on Moodle-) Fratzscher, Marcel et al (2013) On the international spillovers of US quantitative easing, ECB Working Paper 1557, June Powell, J. (2013) Advanced economies monetary policy and emerging market economies, Federal Reserve Bank of San Francisco, 2013 Asia Economic Policy Conference Sanchez, M. (2013) The impact of monetary policies of advanced countries on emerging markets, mimeo

Obstfeld, M. (1998) The global capital market: benefactor or menace?, Journal of Economic Perspectives, vol. 12 (4), Fall, pp. 9-30

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2. EXCHANGE RATES: THEORIES AND EVIDENCE

2.1. EQUILIBRIUM RELATIONSHIPS BETWEEN EXCHANGE RATE,
INTEREST RATE AND INFLATION RATE A. Purchasing power parity, covered interest parity, uncovered interest parity, Fisher open condition B. What is the empirical evidence on these relationships and why it is not strong
Textbook reading Pilbeam (Feb 2013 edition), chapter 6 (PPP); chapter 1 pp. 24-27 (CIP); chapter 7 pp. 149-151 (UIP) Required readings *K. Rogoff (1996), The Purchasing Power Parity puzzle, Journal of Economic Literature, 34, June, pp. 647-668 (sections 6 and 7 optional) *Froot K. and R. Thaler (1990) "Anomalies: foreign exchange", Journal of Economic Perspectives, vol. 4, n.3. pp. 179-192.
Further readings (optional) Sarno, L. and M. Taylor (2002) Purchasing Power Parity and the real exchange rate, IMF Staff Papers, vol 49, n.1, pp 65 105. Menkhoff, L. and L. Sarno (2011), The risk in carry trades, http://voxeu.org/index.php?q=node/6265 Taylor, A. M. and M. P. Taylor (2004). "The Purchasing Power Parity Debate." Journal of Economic Perspectives 18(4): 135-58. Froot and Rogoff, (1995) Perspectives on PPP and Long-run Real Exchange Rates (Ch 32) in Grossman and Rogoff (eds.) Handbook of International Economics, vol. 3.

2.2. BALANCE OF PAYMENTS, US CURRENT ACCOUNT DEFICIT AND

GLOBAL IMBALANCES A. Balance of payments: how it works and its relevance for international finance B. US perspective on global imbalances C. Other countries perspective: the other side of the coin D. Global imbalances and the 2007 financial crisis
Textbook reading Pilbeam, chapter 2 (Balance of Payments and National Income Identity for Open
Economy)

Required readings *Obstfed, M. and K. Rogoff (2010) Global imbalances and the financial crisis: products of common causes, Federal Reserve Bank of San Francisco *Borio, C. and P. Disyatat (2010) Global imbalances and the financial crisis: reassessing the role of international finance, Asian Economic Policy Review *Mann, Catherine L. (2002) "Perspectives on the U.S. Current Account Deficit and Sustainability", Journal of Economic Perspectives. Summer, 16 (3):131-52. *Gourinchas, Pierre-Olivier and Helene Rey (2007) From world banker to world venture capitalist: US external adjustment and the exorbitant privilege, in R. Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, NBER volume, U of Chicago (optional section: 1.5)

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Further readings (optional) M. Kumhof, and R. Ranciere (2010) Leveraging inequality, IMF Finance and Development.Eichengreen B. and Y. C. Park (2006) Global imbalances and emerging markets in Teunissen et al (eds), chapter 2 Eichengreen, B. (2011) Exorbitant Privilege, OUP Rebalancing the Global Economy: A Primer for Policymaking (2010) http://www.voxeu.org/reports/global_imbalances.pdfVoxEU.org publication R. Clarida (ed.) (2007) G7 Current Account Imbalances: Sustainability and Adjustment, NBER volume, University of Chicago Press P. Krugman, M. Obstfeld and M. Melitz (2012), International Economics, Pearson, 9th (National Income identity and BoP) Lopez-Mejia (1999) Large Capital Flows: A survey of the Causes, Consequences and Policy Responses, IMF Working Paper 99/17 Eichengreen, B. J. (2003). Capital flows and crises, MIT Press (chapter 3)

2.3. EXCHANGE RATES MODELS: MACROECONOMIC and

MICROSTRUCTURE APPROACHES A. What determines exchange rates according to the theoretical models B. Balance of payments models: price-specie flow theory, elasticities approach, Mundell-Fleming model C. Asset markets models: monetary models, overshooting models, portfolio balance models D. Expectations models and speculative bubbles E. Microstructure of foreign exchange markets: information, traders and trading
Textbook reading Pilbeam (Feb 2013 edition), Sections 3.1 to 3.4; sections 7.3 to 7.7; sections 8.1 to 8.4; chapter 4 (optional) Required readings *Taylor, M (1995) "The economics of exchange rates", Journal of Economic Literature, 33 (1), pp. 13-47 (excluding optional sections: III.3; IV.3; IV.4 and IV.5; V and VI)
Further readings (optional) P. Krugman, M. Obstfeld and M. Melitz (2012), International Economics, Pearson, 9th, parts 3 and 4 Lyons, R. (2001) The microstructure approach to exchange rates, MIT Press, Chapter 6 Heffernan and Sinclair (1990),Modern International Economics, chapters 8, 9 and 10. Levi (2005) International Finance, section on elasticities approach and other exchange rate models Copeland, L. (2004), Exchange Rates and International Finance, FT-Prentice Hall.

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2.4. EXCHANGE RATES MODELS:

EMPIRICAL and BEHAVIOURAL FINANCE EVIDENCE A. Puzzling empirical evidence B. New directions for future research C. Overconfidence in currency markets
Textbook reading Pilbeam (Feb 2013 edition), chapter 9 (especially section 9.8)

Required readings *Oberlechner, T and C. Osler (2012) Survival of overconfidence in currency markets, Journal of Financial and Quantitative Analysis, vol 47, n.1 *Meese, R. (1990) "Currency Fluctuations in the Post-Bretton Woods Era", Journal of Economic Perspectives, Winter, pp. 117-34 to read p. 117- 123 *Frankel J. and A. Rose (1995) Empirical Research on Nominal Exchange Rates in Grossman and Rogoff (eds.) Handbook of International Economics, Vol. 3, pp. 1689-1729 (required sections: 1 to 1.2.1, section 3 and section 4; the rest is optional) *Tversky and D. Kahneman, Judgement under uncertainty: Heuristics and Biases, Science, 1974, n.185, pp. 1124-1131 *R. Shiller (1999) Human Behaviour and the efficiency of the financial system, chapter 20 , volume 1C, in J. Taylor and M. Woodford (eds) Handbook of Macroeconomics, North Holland

Further readings (optional) Lyons, R. (2001) The microstructure approach to exchange rates, MIT Press, Ch 1, 4, 5 Barberis, N., R. Thaler, et al. (2003), A Survey of Behavioral Finance, Handbooks in Economics, vol. 21, Elsevier, pp. 1053-1123. Kahneman, D. (2011) Thinking fast and slow, Penguin P. De Grauwe and M. Grimaldi (2006) The Exchange rate in a behavioural finance framework, Princeton University Press. Dominguez, Kathryn M. E. (2003) "The Market Microstructure of Central Bank Intervention", Journal of International Economics. January, 59 (1):25-45 Evans, G. (1986) "A test for Speculative Bubbles and the Sterling-Dollar rate", American Economic Review Allen, H. and M. P. Taylor (1990). "Charts, Noise and Fundamentals in the London Foreign Exchange Market." The Economic Journal 100, (400, Conference Papers): 49-59. Curcio, R. and C. Goodhart (2000) "Chartism: A Controlled Experiment", in Goodhart,C and R. Payne, The foreign exchange market: Empirical studies with high-frequency data, Macmillan, 2000; pp. 355-79 Shleifer A. (2000) Inefficient Markets, Cambridge University Press, Chapter 1 Kahneman, Daniel; Tversky, Amos (1982) The psychology of preferences, Scientific American, Vol 246(1), January, pp. 160-173

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3. EXCHANGE RATES: POLICY REGIMES AND COORDINATION

3.1

INTERNATIONAL FINANCIAL AND POLITICAL ECONOMY A. Exchange rate regimes in theory and in practice B. Choice of regime C. Historical perspective on international monetary coordination D. The International Monetary System after the 2007 financial crisis

Textbook reading Pilbeam (Feb 2013 edition), sections 11.1 to 5; 11.15 to 16; 11.19 and sections 10.1 to 3 (optional 10.11 and 11.12-14)

Required readings *Dorrucci, E. and J. McKay (2011), The international monetary system after the financial crisis, European Central Bank, Occasional Paper n. 123 (Part 1 only) *McCauley, R. (2011) RMB internationalisation and Chinas financial development, BIS Quarterly Review *Bordo, M. (2003) Exchange rate regime choice in historical perspective, IMF WP 03/160 *Ghosh, A. and J. Ostry (2009) Choosing an exchange rate regime, Finance and Development, December. *Eichengreen, B. (1996) Globalizing capital: a history of the international monetary system, Princeton University Press; pages 192-196. Also of interest but optional: pp. 3-6; 25-35; 42-44; 128-135 *Bordo, M. D., O. F. Humpage, et al. (2012) Epilogue: foreign-exchange-market operations in the twenty-first century, NBER WP 17984

Further readings (optional)

Rose, A. (2011) Exchange rate regimes in the modern era: fixed, floating and flaky, Journal of Economic Literature, 49 (3) Calvo, G.and C. Reinhart (2002) "Fear of Floating", Quarterly Journal of Economics. 117 (2):379-408. Calvo, G. A. and F. S. Mishkin (2003). "The Mirage of Exchange Rate Regimes for Emerging Market Countries." Journal of Economic Perspectives 17(4) C. Reinhart and K. Rogoff (2004) The modern history of exchange rate arrangements: a reinterpretation, Quarterly Journal of Economics, 119 (1) Ho, C. and R. McCauley (2003) "Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies", BIS Working Papers n. 130 (required parts: 1, 2 and 4) Rogoff, K. (1999) International institutions for reducing global financial instability, Journal of Economic Perspectives, Fall Tirole, J. (2002), Financial crises, liquidity, and the international monetary system. Princeton, Princeton University Press

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3.2 THE EUROPEAN ECONOMIC AND MONETARY UNION AND ITS SOVEREIGN DEBT CRISIS A. Optimal currency area: benefits, costs and conditions B. Historical perspective and European preferences C. Stability and Growth Pact D. EMU Sovereign debt crisis

Textbook reading Pilbeam (Feb 2013 edition), chapter 16 and box 10.1,p. 240-242 Required readings *Pisani-Ferry J. (2012) The Euro crisis and the new impossible trinity, BPC, 2012/01 *Paul DeGrauwe (2006) What have we Learnt about Monetary Integration since the Maastricht Treaty?, Journal of Common Markets Studies, 44 (4) *De Grauwe, P. (2010) A mechanism of self-destruction of the eurozone, CEPS, November *De Grauwe, P. andY. Ji (2013) Panick-driven austerity in the Eurozone and its implications, Voxeu.com
Further readings (optional) Micossi, S et al (2013) The new European framework for managing bank crises, CEPS Policy Brief, n 304, November 2013 Enoch, C et al (2013) From fragmentation to financial integration in Europe, IMF De Grauwe (2013) The new bail-in doctrine, CEPS commentary, April 2013 Lane, P. (2006). "The Real Effects of European Monetary Union." Journal of Economic Perspectives 20(4): 47-66.P. De Grauwe (2012), Economics of Monetary Union, Oxford University Press, 9th ed. Eichengreen, B. J. (2003). Capital flows and crises. Cambridge, Massachusetts, MIT Press. (in particular, chapter 8) B. Eichengreen and C. Wyplosz (1998) The stability pact: more than a minor nuisance?, Economic Policy, April, 0 (26), pp. 65-104 Buti, Marco, Sylvester Eijffinger, and Daniele Franco (2003) "Revisiting EMU's Stability Pact: A Pragmatic Way Forward", Oxford Review of Economic Policy. Spring, 19 (1):10011. Corsetti, G. and P. Pesenti (1999) Stability, Asymmetry and Discontinuity: the outset of the European Monetary Union, Brookings Papers, pp. 295-372 Buiter, W. (2000) Optimal Currency Areas: Why Does the Exchange Rate Regime Matter?, Scottish Journal of Political Economy, 47 (3), August, pp. 213-250 (part on OCA) Levin, J. H. (2000) The History of the European Monetary Unification, chapter 2, In A guide to the Euro, Houghton Mifflin Co., New York Buiter, Corsetti and Pesenti (1999), Financial Markets and European Policy Cooperation: the lessons of the 1992-1993 ERM crisis, Cambridge University Press and CEPR Chapter 1 Tavlas, G. (1993) The New Theory of Optimum Currency Areas, The World Economy, vol. 16 Gros D. and N. Thygesen (1998) European Monetary Integration, Longman, 2nd edition.

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4. EXCHANGE RATE RISK AND FINANCIAL CRISES

4.1 STRUCTURE AND CONVERGENCE OF FINANCIAL SYSTEMS

A. Functions of a financial system B. International comparison: implications of differences and issue of convergence C. Misfunctioning of financial system during the 2007 financial crisis

Required readings *Cecchetti, S and E. Kharroubi (2012) Reassessing the impact of finance on growth, BIS Working Paper n. 381 *Allen,F. and D. Gale (2000) Comparing Financial Systems, MIT Press, Chapter 1 *Turner, A. (2010) What do banks do? Why do credit booms and busts occur and what can public policy do about it?, in The future of finance, LSE Report, CEP, Chapter 1 required pp. 5-13 and 38-42

Further reading (optional) Fan J., S. Titman and F Twite (2012) An international comparison of capital structure and debt maturity choices, Journal of Financial and Quantitative Analysis, vol 47, n 1 Allen F., Jun Qian, Chenying Zhang, Mengxin Zhao (2012) Chinas financial system: opportunities and challenges, NBER Working Paper 17828, February Pilbeam (Feb 2013 edition), chapters 15, 17, 18 (1980s debt crisis, 1997 Asian crisis and 2007 crisis) Mayer, C. (2013) Firm commitment, Oxford University Press The future of finance, (2010), LSE Report, CEP, http://www.futureoffinance.org.uk/ Beck, Levine and Loayza (2000), Finance and the sources of growth, Journal of Financial Economics, 58 (1-2) Rajan, R. and L. Zingales (1998) Financial dependence and growth, American Economic Review Bertero E. and Rondi L. (2000) Financial Pressure and the Behaviour of Public Enterprises under Soft and Hard Budget Constraints: Evidence from Italian Panel Data, Journal of Public Economics 75(1):73-98. Bertero, E. and Rondi, L. (2003). Hardening a Soft Budget Constraint through 'Upward Devolution' to a Supranational Institution:The Case of the European Union and Italian State-Owned Firms In L. Sun (Ed.), Ownership and Governance of Enterprises: Recent Innovative Developments. London: Palgrave/Macmillan.

4.2 FINANCIAL CRISES: STUDENTS group research project ESSAYS

See separate handout

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5. EXCHANGE RATE RISK: MEASUREMENT AND MANAGEMENT

5.1 FOREIGN EXCHANGE RISK: EXPOSURE, MANAGEMENT AND HEDGING

A. B. C. D.

Measuring exposure to exchange rate risk by firms and investors Hedging of currency risk exposure by non-financial firms The functioning of forex markets and significant statistics Hedging vs speculation in forex markets

Required readings *Adler, M. and B. Dumas (1984) "Exposure to Currency Risk: Definition and Measurement", Financial Management, Summer, pp. 41-50. *Geczy, C., B. Minton and C. Schrand (1997) Why firms use currency derivatives, Journal of Finance, vol. 52, n. 4, September, pp. 1323-1354 BIS (2010) Foreign exchange and derivatives market activity, Triennial Central Bank survey, http://www.bis.org/publ/rpfxf10t.htm

Further readings (optional) Sercu and Uppal, chapters 16, 17.1 and 17.2; 18.3.1 to 18.3.4 (specific suggestions in lecture handout) Pilbeam (Feb 2013 edition), Chapter 1 (beware of exchange rate in indirect quotation) Dominguez, Kathryn M. E., and Linda L. Tesar (2001) "A Re-examination of Exchange Rate Exposure", American Economic Review. May, 91 (2):396-99 Levi, M. and P. Sercu (1992) Erroneous and valid reasons for hedging foreign exchange exposure, Journal of Multinational Financial Management, vol. 1, n.2, pp-2537.

5.2 CURRENCY OPTIONS, FUTURES AND SWAPS AND THE INTERNATIONAL FOREIGN EXCHANGE MARKET A. Currency instruments and hedging B. Why do firms use currency derivatives?
Required (and textbook) reading Pilbeam (Feb 2013 edition), chapter 13
Further readings (optional) Garman M. and S. Kohlhagen (1983) "Foreign Currency Options Values", Journal of International Money and Finance, December, pp. 231-7. The future of computer trading in financial markets: an international perspective, the Foresight Report (2012) J. Hull (2009) Options, Futures and Other Derivatives, 7th edition; sections on currency instruments Shapiro, A. (2010) Multinational Financial Management, 9th edition, chapters 8 and 9.

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