Topic 1 ::

Introductionon

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Introduction to International Finance

▶ Finance in an international context…

▶ Why do we need to study international finance?
▶ We are living in a highly globalized and integrated
world economy
▶ Continued liberalization of international trade
further internationalizes the consumption pattern
▶ Globalized production: MNCs source inputs and locate
productions anywhere in the world
▶ Integrated financial markets: internationally diversified
investment, internationally tradable financial securities

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Cont..

• International Finance is the study of monetary interactions that takes place between two
or more countries.

• International Finance is the part of the Financial Economics, It mainly focuses on area
such as Interest rates, Exchange rates, Foreign Direct Investment (FDI), Foreign Portfolio
Investment (FPI), Procurement or allocation of funds, Monetary system of the world and
other aspects associated with international financial management.

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What makes international finance
special?
▶ Three major dimensions make international finance different from purely
domestic finance:
▶ Foreign exchange and political risks
▶ Market imperfections
▶ Expanded opportunity sets

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What makes international finance special?
Foreign exchange and political risks

▶ Unexpected fluctuations of the exchange rates may adversely affect the MNCs
as well as individuals who are engaged in cross border transactions
▶ Exchange rate uncertainty may affect all the major economic functions
including consumption, production, and investment.
▶ Sovereign country can change the rules, e.g.,
▶ Tax rules
▶ Expropriation of assets
▶ In some countries, there is a lack of tradition of the rule of law.

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What makes international finance special?
Market imperfections

▶ Market imperfections represent various frictions and impediments preventing

markets from functioning perfectly.
▶ Such frictions/ impediments/ barriers include
▶ Legal restrictions
▶ Excessive transportation and transaction costs
▶ Information asymmetry
▶ Discriminatory taxation

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What makes international finance special?
Market imperfections

▶ Often, MNCs are motivated to locate production overseas due to such market
imperfections
▶ Imperfection in the international financial market often restrict the extent to
which investors can diversify their portfolios.

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What makes international finance special?
Expanded opportunity set

▶ If firms venture into the arena of global markets, they can benefit from an
expanded opportunity set by:
▶ locating production in any country/region of the world to maximize
performance
▶ raising fund in any capital market where the cost capital is the lowest.
▶ deploying assets on a global basis to gain from greater economies of scale.

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What makes international finance
special?
▶ International finance is different from domestic finance and to be benefitted
from it,
▶ maximize the benefits from the global opportunity set
▶ control exchange rate and political risks
▶ manage various market imperfections

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Effective international financial
management
▶ Effective financial management requires an underlying goal.
▶ Shareholder wealth maximization is considered as the fundamental goal of
sound financial management.
▶ Shareholder wealth maximization is long accepted as a goal in the Anglo-
Saxon countries like Australia, Canada, UK, and USA.

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Effective international financial
management
▶ In other countries like France or Germany, shareholders are viewed as merely
one among many “stakeholders” of the firm including:
▶ Employees
▶ Suppliers
▶ Customers
▶ In Japan, managers have typically sought to maximize the value of the
keiretsu—a family of firms to which the individual firms belongs.

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Effective international financial
management
▶ As a result of recent liberalization and international integration of capital
markets even the managers in France, Germany, Japan, and other non-Anglo-
Saxon countries are beginning to pay serious attention to shareholder wealth
maximization.
▶ Shareholder wealth maximization does not imply that the firm would not
pursue other goals.
▶ Rather, shareholder wealth maximization also helps accomplishing other
legitimate goals.

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Effective international financial
management
▶ As shown by a series of recent corporate scandals at companies like Enron,
WorldCom, and Global Crossing, managers may pursue their own private
interests at the expense of shareholders when they are not closely monitored.
▶ These calamities have painfully reinforced the importance of corporate
governance, i.e., the financial and legal framework for regulating the
relationship between a firm’s management and its shareholders.

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Effective international financial
management
▶ These types of issues can be much more serious in many other parts of the
world, especially emerging and transitional economies, such as Indonesia,
Korea, and Russia, where legal protection of shareholders is weak or virtually
non-existing.

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Globalization of the World Economy:
Major Trends and Developments
▶ Key trends and developments include:
▶ Emergence of Globalized Financial
Markets
▶ Emergence of the Euro as a Global
Currency
▶ Europe’s Sovereign Debt Crisis of 2010
▶ Trade Liberalization and Economic
Integration
▶ Privatization
▶ Global Financial Crisis of 2008-2009

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Globalization of the World Economy:
Emergence of globalized financial markets

▶ Deregulation of Financial Markets

▶ Advances in Technology
▶ have greatly reduced information and transaction costs, which has
led to:
▶ Financial Innovations, such as
▶ Currency futures and options
▶ Multi-currency bonds
▶ Cross-border stock
listings
▶ International mutual
funds

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Globalization of the World Economy:
Emergence of the euro as a global currency

▶ The advent of the euro in 1999 represents a momentous event in the history
of world financial system
▶ More than 300 million Europeans are using the common
currency
▶ Many new members of the EU would
like to adopt the euro
▶ The transaction domain of the euro may become larger
than the USD in near future

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Globalization of the World Economy:
Europe’s sovereign-debt crisis of 2010
▶ All EU member states are automatically members of both the Economic and
Monetary Union (EMU) and the Stability and Growth Pact (SGP)
▶ SGP is an agreement, among the member states of the European Union, to
facilitate and maintain the stability of the EMU
▶ The SGP requires each Member State to implement a fiscal policy aiming for
the country to stay within the limits on government deficit (3% of GDP)

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Globalization of the World Economy:
Europe’s sovereign-debt crisis of 2010
▶ In December 2009, the new Greek government revealed that the actual
budget deficit was 12.7 percent compared to the previously forecasted 3.7
percent based on falsified national account data
▶ Therefore, Greece actually was in a serious violation of the SGP.
▶ This situation was a result of excessive borrowing and spending, with wages
and prices rising faster than productivity

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Globalization of the World Economy:
Europe’s sovereign-debt crisis of 2010
▶ Greece could not use the traditional means of depreciating national currency
as the country had adopted the euro.
▶ Investors became worried about sovereign default
▶ They started to sell off Greek government bonds
▶ The panic spread to other weak European countries, especially Ireland,
Portugal, and Spain

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Globalization of the World Economy:
Europe’s sovereign-debt crisis of 2010
▶ In 2010, credit rating agencies downgraded the government bonds of the
affected countries
▶ Borrowing and refinancing became more costly
▶ Although the debt crisis in Greece accounted for only about 2.5% of
Eurozone
GDP, it quickly escalated to a Europe-wide debt crisis

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Globalization of the World Economy:
Europe’s sovereign-debt crisis of 2010

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Globalization of the World Economy:
Europe’s sovereign-debt crisis of 2010
▶ On May 9, 2010, EU countries led by France and Germany, jointly with IMF, put
together a massive Euro 750 billion package to bail out Greece and other
weak countries.
▶ The agreement on the bailout plan was slow and thus became expensive due
to
▶ Europe’s lack of political union
▶ Fragmented decision making structure

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Globalization of the World Economy:
Trade liberalization and economic integration
▶ Over the past 50 years, international trade increased about twice as fast as
world GDP.
▶ There has been a change in the attitudes of many of the world’s governments,
who have abandoned mercantilist views and embraced free trade as the
surest route to prosperity for their citizenry.

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Globalization of the World Economy:
Trade liberalization and economic integration
▶ The General Agreement on Tariffs and Trade (GATT) is a multilateral
agreement among member countries that has reduced many barriers to trade.
▶ The World Trade Organization (WTO) has the power to enforce the rules of
international trade.

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Globalization of the World Economy:
Trade liberalization and economic integration
▶ The European Union (EU) was established to foster economic integration
among the countries of Western Europe.
▶ The North American Free Trade Agreement (NAFTA) calls for phasing out
impediments to trade between Canada, Mexico, and the United States over a
15-year period beginning in 1994.

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Globalization of the World Economy:
Privatization
▶ The selling of state-run enterprises to investors is also known as
“denationalization.”
▶ Privatization is often seen as socialist economies in transition to market
economies.
▶ By most estimates, this increases the efficiency of the enterprise.
▶ It also often spurs a tremendous increase in cross-border investment.

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Globalization of the World Economy:
Global financial crisis of 2008—2009
▶ The “Great Recession” was the most serious, synchronized economic
downturn since the Great Depression of the 1930s.
▶ Factors included:
▶ Households and financial institutions borrowed too much and took
too much risk.
▶ This risk was repackaged with securitization.

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Multinational Corporations

▶ A multinational corporation (MNC) is a

firm that has been incorporated in one
country and has production and sales
operations in other countries.
▶ There are about 60,000 MNCs in the
world.
▶ Many MNCs obtain raw materials from
one nation, financial capital from
another, produce goods with labor and
capital equipment in a third country,
and sell their output in various other
national markets.

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A multinational corporation (MNC) has facilities and other assets in at
least one country other than its home country.

A multinational company generally has offices and/or factories in

different countries and a centralized head office where they coordinate
global management.

Some of these companies, also known as international, stateless, or

transnational corporate organizations, may have budgets that exceed
those of some small countries.

There are four categories of multinationals that exist. They include:

• A decentralized corporation with a strong presence in its home
country.
• A global, centralized corporation that acquires cost advantage where
cheap resources are available.
• A global company that builds on the parent corporation’s R&D.
• A transnational enterprise that uses all three categories. business and
operational decisions in and outside of its headquarters.
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There are subtle differences between the different kinds
of multinational corporations. For instance, a
transnational—which is one type of multinational—may
have its home in at least two nations and spread out its
operations in many countries for a high level of local
response. Nestlé S.A. is an example of a transnational
corporation that executes business and operational
decisions in and outside of its headquarters.

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Why Would a Company Want to
Become Multinational?
• A company may seek to become an MNC to grow its customer
base around the globe and increase its market share abroad.
• The primary goal is therefore to increase profits and growth.
• Companies may want to introduce their products in ways that
are modified or tailored to specific cultural sensibilities
abroad.
• MNCs may also benefit from certain tax structures or regulatory
regimes found abroad.

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How a Multinational Corporation
(MNC) Works
• A multinational corporation, or multinational enterprise, is an
international corporation whose business activities are spread
among at least two countries.

• Some authorities consider any company with a foreign branch to

be a multinational corporation; others limit the definition to only
those companies that derive at least a quarter of their revenues
outside of their home country.

• Many multinational enterprises are based in developed nations.

Multinational advocates say they create high-paying jobs and
technologically advanced goods in countries that otherwise would
not have access to such opportunities or goods.

• However, critics of these enterprises believe these corporations

have undue political influence over governments, exploit 34

developing nations, and create job losses in their own home

countries.
Cont..
• The history of the multinational is linked with the history of colonialism.
• Many of the first multinationals were commissioned at the behest of European
monarchs to conduct expeditions. Many of the colonies not held by Spain or
Portugal were under the administration of some of the world's earliest
multinationals.
• One of the first arose in 1600: the British East India Company, which took part in
international trade and exploration, and operated trading posts in India.
• Other examples include the Swedish Africa Company, founded in 1649, and the
Hudson's Bay Company, which was founded in the 17th century.

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Objectives of MNC
To expand the business beyond the boundaries of the home country.

To minimize cost of production, especially labour cost.

To avail of competitive advantage internationally.

To establish an international corporate image.

To achieve greater efficiency by producing in local market and then

exporting the products.

To make best use of technological advantages by setting up production

facilities abroad.

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Considerations in International
Financial Management:
• Must consider the effect of exchange rates and changes in exchange
rates in the inter-country transfer of cash flows.

• Must consider the political risk associated with actions of foreign

governments.

• Must consider how accounting methods, tax laws, business

regulations, and their institutional rules and arrangements affect
business transactions and cash flows in each country in which the
firm does business, adding to the complexity of foreign operations.

• Must consider language and cultural differences when dealing in

international commerce.
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Role of international financial manager
1.Currency Transactions
2.Managing foreign exchange risk exposure
3.Global Money Management
4.Financing International Business Operations

1. Currency Transactions
1. It takes place when MNC’s wants to make foreign investment.
2. Making payments to the clients

Types of Currency Transactions

Spot Trade – An agreement to trade currencies based on the exchange
rate today for settlement immediately (“on the spot”), technically within
two business days.

Forward Trade – An agreement to exchange currency at a specified future

date at a specified price agreed upon today(also called a forward
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contract).
2.Foreign exchange risk :

It is the possibility of a gain or loss to a firm that occurs due to

unanticipated changes in exchange rate.

Types of foreign exchange risk exposure

• Translation Exposure
• Transactions Exposure
• Economic Exposure

Translation Exposure -It Relates to the change in accounting income and

balance sheet statements caused due to changes in exchange rates.

Transactions Exposure – It refers to the extent to which the future value

of the firm’s domestic cash flow is affected by exchange rate
fluctuations.

Economic Exposure – It refers to the degree to which a firm's present

value of future cash flows can be influenced by exchange 39 rate
fluctuations.
3. Global Money Management:
Money management decisions attempt to manage global cash
resources efficiently.
It includes:
• Minimizing Cash Balances
• Reducing Transaction Costs

4.Financing International Business Operations

• EXIM Bank (Export-Import Bank).
• Loans from the parent company or a sister affiliate.
• Eurodollar loans.
• Eurobond market.
• International Equity markets.
• The International Finance Corporation (IFC).

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