Chapter One

Introduction to International
Finance
 What is international finance?
International Finance is one of the broad disciplines in a field of international
economic.
International economics is a field of study that assesses the implications of
international trade, international investment, and international borrowing
and lending.
International finance sometimes known as international macroeconomics is
a section of financial economics that deals with the monetary interactions
that occur between two or more countries.
WHAT IS INTERNATIONAL FINANCE?
International finance applies macroeconomic models which help to
understand the international economy.
Its focus is on the interrelationships among aggregate economic
variables such as GDP, unemployment rates, inflation rates, trade
balances, exchange rates, interest rates, and so on.
This field expands basic macroeconomics to include international
exchanges.
WHAT IS INTERNATIONAL FINANCE?
Its focus is on the significance of trade imbalances, the
determinants of exchange rates, and the aggregate effects of
government monetary and fiscal policies.
The pros and cons of fixed versus floating exchange rate systems
are among the important issues addressed in the discipline .
WHAT IS INTERNATIONAL FINANCE?
International finance also involves issues pertaining to financial
management, such as political and foreign exchange risk that comes
with managing Multinational corporations.
 SPECIAL FEATURES OF
INTERNATIONAL FINANCE
An international business is exposed to altogether a different
economic and political environment.
For Example: All trade policies are different in different countries.
One country may have business friendly policies and other may
not.
Thus, financial manager has to critically analyze the policies to
make out the feasible and profitability of their business
propositions.
SPECIAL FEATURES OF
INTERNATIONAL FINANCE
International finance is different from domestic finance (just finance)
in many aspects and
first and the most significant of them is foreign currency exposure.
There are other aspects such as the different political, cultural, legal,
economical, and taxation environment.
International financial management involves a lot of currency
derivatives whereas such derivatives are very less used in domestic
financial management.
SPECIAL FEATURES OF
INTERNATIONAL FINANCE
If we talk on a macro level, the most
important difference between
international finance and domestic finance
is foreign currency or to be more precise
the exchange rates.
Thus, the important distinguishing features
of international finance from domestic
financial management are discussed below:
SPECIAL FEATURES OF
INTERNATIONAL FINANCE

(1) Foreign Exchange Risk

(2) Political Risk
(3) Market Imperfections
(4) Expanded Opportunity Set

(1) Foreign Exchange Risk

Many of these problems are due to the use of different
currencies used in different countries and the consequent need to
exchange them
SPECIAL FEATURES OF
INTERNATIONAL FINANCE
The rates of exchange between currencies the amount of a
currency received for another have been set by a variety of
arrangements, with the rates of exchange as well as the
arrangements themselves subject to change.
Movements in exchange rates between currencies can have
profound effects on sales, costs, profits, asset and liability values,
and individual wellbeing.
SPECIAL FEATURES OF
INTERNATIONAL FINANCE
Other special, uniquely international financial problems arise from
the fact that there are political divisions as well as currency divisions
between countries
The risk that foreign currency profits may evaporate in dollar terms
due to unanticipated unfavorable exchange rate movements.
SPECIAL FEATURES OF
INTERNATIONAL FINANCE
(2) Political Risk
Sovereign governments have the right to regulate the movement of goods, capital,
and people across their borders. These laws sometimes change in unexpected ways.

(3) Market Imperfections

Legal restrictions on movement of goods, people, and money
Transactions costs
Shipping costs
Tax arbitrage
SPECIAL FEATURES OF
INTERNATIONAL FINANCE
(4) Expanded Opportunity Set
Political barriers provide additional opportunities and risks when
engaging in overseas borrowing and investment.
International finance has as its focus the problems managers face
from these currency and country divisions and the associated
opportunities and risks
 THE BENEFITS OF INTERNATIONAL
FINANCE
Knowledge of international finance can help a financial manager
consider how international events may affect a firm and what steps
can be taken to exploit positive developments and insulate the firm
from harmful ones.
Among the events that affect the firm and that must be managed are
changes in exchange rates as well as interest rates, inflation rates, and
asset values.
THE BENEFITS OF INTERNATIONAL
FINANCE
These different changes are themselves related. For example,
declining exchange rates tend to be associated with relatively high
interest rates and inflation.
Note: Given other things constant; when a countrys inflation rate rises
relative to that of another country, decreased exports and increased
imports depress the high-inflation countrys currency.
THE BENEFITS OF INTERNATIONAL
FINANCE
Furthermore, some asset prices are positively affected by a declining
currency, such as stock prices of export-oriented companies that are
more profitable after devaluation.
Other asset prices are negatively affected, such as stock prices of
companies with foreign-currency denominated debt that lose when the
companys home currency declines: the companys debt is increased in
terms of domestic currency.
THE BENEFITS OF INTERNATIONAL
FINANCE
These connections between exchange rates, asset and liability values
and so on mean that foreign exchange does not simply add an extra
exposure and risk to other business exposures and risks.
Instead, the amount of exposure and risk depends crucially on the
way exchange rates and other financial prices are connected.
THE BENEFITS OF INTERNATIONAL
FINANCE
For example, effects on investors in foreign countries when exchange
rates change depend on whether asset values measured in foreign
currency move in the same direction as the exchange rate, thereby
reinforcing each other, or in opposite directions, thereby offsetting
each other.
Only by studying international finance can a manager understand
the aforementioned matters.
THE BENEFITS OF INTERNATIONAL
FINANCE
There are other reasons to study international finance beyond
learning how exchange rates affect asset prices, profits and other
effects described above.
THE BENEFITS OF INTERNATIONAL
FINANCE
International Finance used to handle the problems faced by any
country or any firm whose performance is affected by developments in
the international environment
Even countries and companies that are domestically focused but
compete with firms producing abroad and selling in their local markets
are affected by international developments.
 THE BENEFITS OF INTERNATIONAL
ForFINANCE
Example:
Chinese auto-part or appliance manufacturers with no overseas sales will find
home country sales and profit margins affected by exchange rates which
influence the home currency prices of imported auto parts and appliances: an
appreciation of the Chinese currency lowers prices of products imported into
China.
THE BENEFITS OF INTERNATIONAL
FINANCE
It is also relevant to the multitude of companies that have explored
international opportunities by forming joint ventures outside their own
borders.
Indeed, it is just as valid for countries and companies with a
predominantly domestic focus that happen to export a little of their
output or to buy inputs from abroad.
THE BENEFITS OF INTERNATIONAL
FINANCE
Similarly, bond investors holding their own governments bonds,
denominated in their own currency, and spending all their money at
home, are affected by changes in exchange rates if exchange rates
prompt changes in interest rates.
Specifically, if governments increase interest rates to defend their
currencies when their currencies fall in value on the foreign exchange
markets, holders of domestic bonds will find their assets falling in
value along with their home currencies: bond prices fall when interest
rates increase.
THE BENEFITS OF INTERNATIONAL
FINANCE
Remark
It is difficult to think of any firm or country that is not affected in
some way or other by the international financial environment.
Inflation, jobs, economic growth rates, bond and stock prices, oil and
food prices, government revenues and other important financial
variables are all tied to exchange rates and other developments in
the increasingly integrated, global financial environment.
 THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS
A variety of International Institutions have been established to
facilitate international trade and financial transactions.
These International Institutions often represent a group of nations.
A description of some of the more important Institutions depicted as
follows:
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

International Monetary Fund (here after IMF)

The United Nations Monetary and Financial Conference held in
Bretton Woods, New Hampshire, in July 1944, was called to develop
a structured international monetary system.
As a result of this conference, the IMF was formed.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

The IMF is overseen by a Board of Governors, composed of finance

officers (such as the head of the central bank) from each of the 185
member countries.
It also has an executive board composed of 24 executive directors
representing the member countries.
This board is based in Washington, D.C., and meets at least three
times a week to discuss ongoing issues.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

One of the key duties of the IMF is its compensatory financing

facility (CFF), which attempts to reduce the impact of export instability
on country economies.
Although it is available to all IMF members, this facility is used
mainly by developing countries.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

A country experiencing financial problems due to reduced export

earnings must demonstrate that the reduction is temporary and beyond
its control.
In addition, it must be willing to work with the IMF in resolving the
problem.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Each member country of the IMF is assigned a quota based on a

variety of factors reflecting that countrys economic status.
Members are required to pay this assigned quota.
The amount of funds that each member can borrow from the IMF
depends on its particular quota.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

The financing by the IMF is measured in special drawing rights

(SDRs). The SDR is not a currency but simply a unit of account.
SDR is an international reserve asset created by the IMF and
allocated to member countries to supplement currency reserves.
The SDRs value fluctuates in accordance with the value of major
currencies.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

The major objectives of the IMF, as set by its charter, are to

(1) promote cooperation among countries on international monetary
issues,
(2) promote stability in exchange rates,
(3) provide temporary funds to member countries attempting to
correct imbalances of international payments,
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

(3) promote free mobility of capital funds across countries, and

(4) promote free trade.
It is clear from these objectives that the IMFs goals encourage
increased internationalization of business.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

World Bank
The International Bank for Reconstruction and Development
(IBRD), also referred to as the World Bank, was established in 1944.
Its primary objective is to make loans to countries to enhance
economic development.
For example, the World Bank recently extended a loan to Mexico for
about $4 billion over a 10-year period for environmental projects to
facilitate industrial development near the U.S. border.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Its main source of funds is the sale of bonds and other debt
instruments to private investors and governments.
The World Bank has a profit-oriented philosophy.
Therefore, its loans are not subsidized but are extended at market
rates to governments (and their agencies) that are likely to repay
them.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

A key aspect of the World Banks mission is the Structural

Adjustment Loan (SAL), established in 1980.
The SALs are intended to enhance a countrys long-term economic
growth.
For example, SALs have been provided to Turkey and to some less
developed countries that are attempting to improve their balance of
trade.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS
Because the World Bank provides only a small portion of the financing
needed by developing countries, it attempts to spread its funds by entering
into co-financing agreements.
Co-financing is performed in the following ways:
Official aid agencies. Development agencies may join the World Bank in
financing development projects in low-income countries.
Export credit agencies. The World Bank co-finances some capital-intensive
projects that are also financed through export credit agencies.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Commercial banks. The World Bank has joined with commercial

banks to provide financing for private-sector development. In recent
years, more than 350 banks from all over the world have participated
in co-financing, including Bank of America, J.P. Morgan Chase, and
Citigroup.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

The World Bank recently established the Multilateral Investment

Guarantee Agency (MIGA), which offers various forms of political
risk insurance.
This is an additional means (along with its SALs) by which the World
Bank can encourage the development of international trade and
investment.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

The World Bank is one of the largest borrowers in the world

Its loans are well diversified among numerous currencies and countries.
It has received the highest credit rating (AAA) possible.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

World Trade Organization

WTO was created as a result of the Uruguay Round of trade
negotiations that led to the General Agreement on Tariffs and Trade
(GATT) accord in 1993.
This organization was established to provide a forum for multilateral
trade negotiations and to settle trade disputes related to the GATT
accord.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

It began its operations in 1995 with 81 member countries, and more

countries have joined since then.
Member countries are given voting rights that are used to make
judgments about trade disputes and other issues
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

International Financial Corporation

In 1956 the International Financial Corporation (IFC) was
established to promote private enterprise within countries.
Composed of a number of member nations, the IFC works to promote
economic development through the private rather than the government
sector.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

It not only provides loans to corporations but also purchases stock,

thereby becoming part owner in some cases rather than just a creditor.
The IFC typically provides 10 to 15 percent of the necessary funds in
the private enterprise projects in which it invests, and the remainder of
the project must be financed through other sources.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Thus, the IFC acts as a catalyst, as opposed to a sole supporter, for

private enterprise development projects.
It traditionally has obtained financing from the World Bank but can
borrow in the international financial markets.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

International Development Association

The International Development Association (IDA) was created in
1960 with country development objectives somewhat similar to those
of the World Bank.
Its loan policy is more appropriate for less prosperous nations,
however.
The IDA extends loans at low interest rates to poor nations that cannot
qualify for loans from the World Bank.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Bank for International Settlements

The Bank for International Settlements (BIS) attempts to facilitate
cooperation among countries with regard to international transactions.
It also provides assistance to countries experiencing a financial crisis.
The BIS is sometimes referred to as the central banks central bank
or the lender of last resort.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

It played an important role in supporting some of the less developed

countries during the international debt crisis in the early and mid-
1980s.
It commonly provides financing for central banks in Latin American
and Eastern European countries.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Organization for Economic Cooperation and Development

The Organization for Economic Cooperation and Development
(OECD) facilitates governance in governments and corporations of
countries with market economics.
It has 30 member countries and has relationships with numerous
countries.
The OECD promotes international country relationships that lead to
globalization.
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

Regional Development Agencies

Several other agencies have more regional (as opposed to global)
objectives relating to economic development.
These include, for example, the Inter-American Development Bank
(focusing on the needs of Latin America), the Asian Development Bank
(established to enhance social and economic development in Asia),
and the African Development Bank (focusing on development in
African countries).
THE EMERGENCE OF INTERNATIONAL
INSTITUTIONS

In 1990, the European Bank for Reconstruction and Development was

created to help the Eastern European countries adjust from communism
to capitalism.
Twelve Western European countries hold a 51 percent interest, while
Eastern European countries hold a 13.5 percent interest.
The United States is the biggest shareholder, with a 10 percent
interest.
There are 40 member countries in aggregate.
 WHY DO COMPANIES EXPAND
INTERNATIONALLY?
Expand Markets and Increase Sales

Expanded markets and increased sales mean

more profits.
Profits mean success for a business.
They also mean that a business can make
contributions to causes that they believe in.
For example, MAC Cosmetics is a business that
increased sales and broadened their markets in order
to become more successful. This business started as a
small idea and eventually expanded to a greater
establishment by going international.
WHY DO COMPANIES EXPAND
INTERNATIONALLY?

MAC Cosmetics really did expand their markets. They ended up

selling their product in 118 countries, controlled 45% of cosmetic sales
and had $3.6 million in USD
WHY DO COMPANIES EXPAND
INTERNATIONALLY?

Controlling Expenses
Every business wants to have low expenses; so some companies will
therefore enter the global arena to minimize their costs.
Companies will examine the resources they need and where they can
get them at the lowest price.
By searching outside of their own borders, companies hope to find
more economical solutions to the production and manufacturing
problems they have.
WHY DO COMPANIES EXPAND
INTERNATIONALLY?
Business might choose to take advantage of lower labor costs, they
might move manufacturing plants closer to natural resources, invest in
new and more efficient technology, or profit from another countries
innovations or tax structures.
WHY DO COMPANIES EXPAND
INTERNATIONALLY?
For example: a company that is located in Toronto that gets most of
their resources from Japan might want to look into moving the
company closer to Japan or they might have to look into finding a new
place to get their resources.
WHY DO COMPANIES EXPAND
INTERNATIONALLY?
Diversification
In order to diversify a companys product line they may choose to
enter a specific international market.
This will apply to both a large scale international business along with
a small company.
WHY DO COMPANIES EXPAND
INTERNATIONALLY?
Companies have a foothold in a number of countries so they dont
have to depend on the economy of one country.
Companies engaged in international business can protect their
investments and their markets by dealing with countries in a variety of
countries.
A recession in one county wont have a huge effect if business is doing
well in another country
WHY DO COMPANIES EXPAND
INTERNATIONALLY?
Competitiveness
Many companies expand globally for defensive reasons-to protect
themselves from competitors or potential competitors, or to gain
advantage over them.
In todays business environment, even a small business is competing
with international businesses. For Example: A neighborhood video
store is facing competition from a larger international company such
as Blockbuster Video.
WHY DO COMPANIES EXPAND
INTERNATIONALLY?
A local store may have a limited selection because of its small size
but it may be able to offer more personal service, a more specialized
stock or even lower prices.
On the other hand, local businesses may find if difficult to compete
with the selection and price that multinational companies can offer.
If their businesses are too threatened, they may find wider markets or
merge with a larger, possibly international company.
End of Chapter One.