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International Finance:Putting Theory Into Practice

Piet SercuLeuven School of Business and Economics

Katholieke Universiteit Leuven

14:20 on 2 July 2008

Preface

About this book

This book had a forerunnerInternational Financial Markets and The Firm, co-authored with Raman Uppal, which came out in 1995. By 2003 or 2004 Raman andI had agreed that a text full of Italian Lira or German Marks and where tradersstill had a full two minutes to respond to market makers quotes, might sooner orlater risk getting outdated. Starting the revision itself turned out to be much moredifficult than agreeing on the principle, though. In the end Raman, being so muchbusier and more rational than I am, preferred to bow out. How right he was. Still,now that the effort has become a sunk cost, forever bygone, I find that episodeswhere I sincerely curse the book (and myself and Princeton University Press) arebecoming fewer and farther between. Actually, there now are several passages Iactually begin to like.

Like the previous book, the book still targets finance students, or at least studentsthat want a genuine finance text, not an international-management or -strategy textwith a finance slant nor an international monetary economics text with some cor-porate applications. There is a continued bias in favor of financial markets andeconomic logic; the aim is to provide students with a coherent picture of interna-tional markets and selected topics in multinational corporate finance. Sure, duringeveryday practice later on, this framework will then get amended and corrected andqualified; but the feeling of fundamental coherence will remain, we hope.

This book is more analytical than the modal text in the field. Compared to theSercu-Uppal book, some of the math has been dropped and new matter has beenadded. As before, a lot of it is in Appendices, thus stressing its optional character.The main difference, I think, is that the in-text math is brought in differently.While in International Financial Markets we had every theorem or proof followedby an example, now the example comes first whenever that is possible. If so, theproof is often even omitted, or turned into a DoItYourself assignment. In fact, athird innovation is that, at least in the chapters or sections that are sufficientlyanalytical rather than just factual, the reader is invited to prove or verify claimsand solve analogous problems. The required level of math is surely not prohibitive;anybody who has finished a good finance course should be able to master theseDoItYourself assignments. Still, while the required level of mathematical prowess is

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low, a capacity for abstract thinking and handling symbols remains vital.

Every Part, except the Intro one, now has its own introductory case, which isintended to stimulate the readers appetite and which can be a source of assignments.The cases usually cover issues from most chapters in the Part.

A fifth change is that the Part on exchange-rate pricing is much reduced. Theformer three Chapters on exchange-rate theories, predictability, and forward bias arenow shrunk to two. And, lastly, three wholly new chapters have been added: two oninternational stock marketsespecially crosslisting with the associated corporate-governance issuesand one on Value at Risk.

Typically, a preface like this one continues with a discussion and motivation ofthe books content. But my feeling is that most readersand surely studentsskip prefaces anyway. Since the motivation of the structure is quite relevant, thatmaterial is now merged into the general introduction chapter, Chapter 1.

How to use this book

The text contains material for about two courses. One possibility is to take thesecond Part, International Financial Markets, as one course, and group the morebusiness-finance oriented material (grouped into Exchange Risk, Exposure, and RiskManagement (III) and Long-Term Financing and Investments (IV)) as a second.Fixed-income markets, which now is in Part III, could be included in the mar-kets/instruments course, like it was in the 1995 book; and the whole package canalso duplicate as an intro derivatives course, along with the apocryphal Chapter ??that is available on my website. I myself run two 40-hr courses covering, respectivelyParts II-III (Instruments, Risk Management) and Part IV (Stocks, bonds, capitalbudgeting).

For one single course one could focus, in Part II, on spot (Chapter 3) and forwards(Chapters 4 and 5), and then continue with the chapters on relevance of hedgingand exposure (Chapters 12 and 13), to finish with capital budgeting (Chapter 21);this shortlist can be complemented by a few chapters of your liking.

Leuven, December 2006.

cP. Sercu, K.U.Leuven. Free copying stops Oct 1st, 08 Formatted 2 July 200814:20.

About the author

Piet Sercu is Professor of International Finance at the Katholieke Universiteit Leu-ven. He holds the degrees of Business Engineer, Master of Business Administration,and Doctor in Applied Economics from K.U. Leuven. He taught at the FlemishBusiness School in Brussels (1980-1986), prior to returning to Leuven, where hecurrently teaches the International Business Finance courses in the Masters andAdvanced Masters programs. He also held Visiting Professor appointments at NewYork University, Cornell University, the University of British Columbia, the Lon-don Business School, and Universite Libre de Bruxelles. He taught shorter financecourses in Helsinki, Bandung (Indonesia), Leningrad, and India (as an UNDP ex-pert and, in 1994, as a fellow of the European Indian Cooperation and ExchangeProgramme), and regularly teaches executive courses. He held the 1996/7 Franc-qui Chair at the Facultes Universitaires Notre-Dame de la Paix at Namur, and the2000/04 PricewaterhouseCoopers Chair on Value and Risk at KU Leuven, togetherwith Marleen Willekens. Until 2000, he organized and taught doctoral courses inthe European Doctoral Education Network, as part of the Finance faculty of theEuropean Institute for Advanced Studies in Management. He was the 1994 Vice-President and 1995 President of the European Finance Association, won the 1999Western Finance Association award for Corporate Finance (with Xueping Wu andCharley Park) and was Hanken Fellow in 2002.

His early research focused on International Asset Pricing with real exchange riskand inflation risk. He also did some work on corporate take-over models and lendingbut has recently returned to International Finance and hedging. He has publishedin the Journal of Finance, Journal of Banking and Finance, Journal of InternationalMoney and Finance, European Economic Review, and other journals. He is on theeditorial boards of the European Financial Management Journal and the Journalfor International Financial Markets, Institutions and Money.

Piet Sercu and Raman Uppal jointly won the 1995 Sanwa Prize for a monographin International Finance, Exchange Rate Volatility, Trade, and Capital Flows underAlternative Currency Regimes, published by Cambridge University Press in 2000and 2006. They also have produced International Financial Markets and The Firm(International Thomson Publishers, Cincinnati-London, 1995), the forerunner tothis book and the source of much of its material. There are also a number of jointacademic articles.

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Acknowledgments

There are many individuals who played an important role in the production ofthis book. First and foremost I thank Raman Uppal, not only for his invaluablecontribution to the first book but also for the discussions about how to structurea new version, for translating the text parts of the old manuscript into LaTeX,and setting up a master file system to produce the whole. Thanks also to theformer and current doctoral students or assistants who read earlier drafts of the firstand second book and suggested several improvements: Badrinath H. R., Thi NgocTuan Bui, Katelijne Carbonez, Cedric de Ville de Goyet, Kathy Dehopere, MarianKane, Fang Liu, Rosanne Vanpee, Tom Vinaimont, and Xueping Wu. Marian,especially, did lots of work on the exercises, and Katelijne on the revised text.Prof. Martina Vandebroek occasionally helped with spreadsheets and graphs, atwhich she Excels; she, Fang Liu and Badrinath H. R. provided the empirical resultsfor Chapters 10 and 11. Many thanks, lastly, to colleagues who read drafts andprovided comments, some of them at Princetons request but some even of theirfree will: Hu Shengmei, Karen Lewis, Bernard Dumas, Stan Standaert, Charles vanWymeersch, and an anonymous (but wholly positive) referee reporting to PrincetonUP. Of course, I remain responsible for all remaining errors. Comments and feedbackfrom readers about errors, presentation, and contents are very welcome: do emailto piet.sercu@econ.kuleuven.be.

I dedicate this book to my parents, Jan Sercu and the late Terese Reynaert,and to my wife Rita and children Maarten and Jorinde, who have patiently put upwith my inattentive absent-mindedness during the time it has taken to completethis project and, come to think of it, most of the time before and after.

December 2007

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Contents

I Introduction and Motivation for International Finance 1

1 Why does the Existence of Borders Matter for Finance? 31.1 Key Issues in International Business Finance . . . . . . . . . . . . . . . . . 4

1.1.1 Exchange-rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.1.2 Segmentation of the Consumer-good Markets . . . . . . . . . . . . 61.1.3 Credit risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.1.4 Political risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.1.5 Capital-Market Segmentation Issues, including Aspects of Corpo-

rate Governance . . . . . . . . . . . . . . . . . . . .