CHAPTER ONE:

Introduction to International finance

1

1.1. International financial management defined

1.2. What is special about IF
1.3. Multinational corporations
1.4. Other international players
1.5. International monetary system
 1.1. International Financial Management
2

 Financial management is mainly concerned with how to

optimally make various corporate financial decisions
(investment, financing, dividend policy, and working capital
management) with a view to achieve a set of given corporate
objectives.

 Decide how international events will affect a firm and what

steps can be taken to exploit positive developments and
insulate the firm from harmful ones.

 Changes in exchange rates as well as interest rates, inflation

rates, and asset values can be managed well
 Need of International FM
3

 Understand matters such as connections between exchange rates,

asset and liability values, and so on.

 Making investment and financing decisions in a global market.

 Cash flows associated with these decisions and the risks associated
with these cash flows.

 The international financial markets.

 Generally, we study international finance because we are now living

in a highly globalized and integrated world economy.
 International Financial Management
4

• Deals with -
– Efficient investment of resources,
– Financing investments at lowest cost, and
– Managing day to day financial activities

- in a global context
 1.2. What’s Special about International
Finance?
5

 Foreign Exchange Risk

 The risk that foreign currency profits may evaporate in

currency terms due to unanticipated unfavorable

exchange rate movements.

 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.
 What’s Special …
6

 Market Imperfections
 Legal restrictions on the movement of goods, people, and

money
 Transaction costs

 Shipping costs

 Tax arbitrage

 Information asymmetry
 What’s Special …
7

 Expanded Opportunity Set

 It doesn’t make sense to play in only one corner of the

sandbox.

 Firms can locate production in any country or region of the

world to maximize their performance and raise funds in
any capital market.

 Firms can gain from greater economies of scale when their

tangible and intangible assets are deployed in global basis.
 Goals for International Finance
8

International finance is designed to provide today's financial

managers with an understanding of the fundamental concepts
and the tools necessary to be effective global managers.

 Maximization of shareholder wealth?

or
 Other Goals?
9

 Maximize Shareholder’s Wealth

 Discounted Cash Flow Valuation Model:
 Other Goals

10

 In some countries shareholders are viewed as merely one among

many “stakeholders” of the firm including: Employees, customers,
suppliers, banks, and so forth.

 Shareholder wealth maximization is a long-run goal.

 A firm cannot stay in business to maximize shareholder wealth if it

treats employees poorly, produces shoddy merchandise, wastes raw
materials and natural resources, operates inefficiently, or fails to
satisfy customers.
 Other Goals …..
11

• For different corporate calamities corporate governance is

essential i.e., financial & legal framework for regulating the
relationship between a firm’s management and its shareholders.

• No matter what the other goals, they cannot be achieved in the

long term if the maximization of shareholder wealth is not given
due consideration.
 Overview of international finance

12
 1.3. Multinational Companies
The International Financial Environment
13

Multinational Corporation (MNC)

Foreign Exchange Markets

Dividend
Remittance
Exporting & Financing Investing
& Importing & Financing

Product Markets Subsidiaries International

Financial
Markets
 What is International business
14
 The study of transactions taking place across national borders for
the purpose of satisfying the needs of individuals and organizations.

 The entities involved in business can be private, governmental, or a

mixture of the two.

 Today it is almost impossible to find a product or service that does

not have an international aspect to its customer base, as well as at
least one element of its supply chain.

 By supply chain, the chain inputs that come from other sources,
including the raw materials, components and equipment used to
produce, store and package the product or service.
 What is International business
15

 There are many forms of international business transactions.

 Trade is not new, as human beings have been engaged in

bartering goods since the dawn of civilization.

 The ‘classical’ view of international business has been

international trade, in the form of exporting and importing.

 International business can be broken down into four types:

 Foreign Trade,

 Trade In Services,

 Portfolio Investments, and

 Direct Investments.
 Types of international Business
16

 Foreign trade- Export and trade

 Trade in Service-

 In addition to tangible goods(i.e. foreign trade), countries also trade

in services, such as insurance, banking, hotels, consulting, and travel
and transportation.
 The earnings can be in the form of fees or royalties.

 Fees are generated through the satisfaction of specific performance

requirements and can be earned through long- or short-term
contractual agreements, such as management or consulting contracts.

 Royalties accrue from the use of one company’s process, name,

trademark, or patent by someone else.
 Types of international Business
17

 Portfolio investments
 are financial investments made in foreign countries.
 The investor purchases debt or equity in the expectation of nothing
more than a financial return on the investment.
 Resources such as equipment, time, or personnel are not contributed to
the overseas venture.
 Direct investments
 are differentiated by much greater levels of control over the project
or enterprise by the investor.
 The level of control can vary from full control, when a firm owns a
foreign subsidiary entirely, to partial control, as in arrangements such
as joint ventures with other domestic or foreign firms or a foreign
government.
18

What are MNCs

 Multinational Companies

19 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.

 
Multinational Companies
The following are the common characteristics of multinational corporations:
20
1. Very high assets and turnover
 To become a multinational corporation, the business must be large and must

own a huge amount of assets, both physical and financial.

2. Network of branches
 Multinational companies maintain production and marketing operations in

different countries. In each country, the business may oversee multiple

offices that function through several branches and subsidiaries.
3. Control
 In relation to the previous point, the management of offices in other countries

is controlled by one head office located in the home country. Therefore, the
source of command is found in the home country.
4. Continued growth
 Multinational corporations keep growing. Even as they operate in other

countries, they strive to grow their economic size by constantly upgrading

and by conducting mergers and acquisitions.
 Multinational Companies
5. Sophisticated technology
21
 When a company goes global, they need to make sure that their
investment will grow substantially. In order to achieve substantial
growth, they need to make use of capital-intensive technology,
especially in their production and marketing activities.
6. Right skills
 Multinational companies aim to employ only the best managers, those
who are capable of handling large amounts of funds, using advanced
technology, managing workers, and running a huge business entity.
7. Forceful marketing and advertising
 One of the most effective survival strategies of multinational
corporations is spending a great deal of money on marketing and
advertising.
8. Good quality products
 Because they use capital-intensive technology, they are able to produce
top-of-the-line products.
 Reasons for Being a Multinational

Corporation
Some of the most common motivations:
22
1. Access to lower production costs
 Due to their large size, MNCs can take advantage of economies of scale and grow
their global brand.
 The growth is done through strategic manufacturing/service placement, which allows
the corporation to take advantage of undervalued services across the globe, more
efficient and inexpensive supply chains, and advanced technological/R&D capacity .
2. Proximity to target international markets
 International brand recognition makes the transition from different
countries and their respective markets easier and decreases per capita
marketing costs as the same brand vision can be applied worldwide.
3. Access to a larger talent pool
 Multinational corporations are also known to hire only the best talent from around
the world, which allows management to provide the best technical knowledge and
innovative thinking to their product or service.
4. Avoidance of tariffs
 When a company produces or manufactures its products in another country where
they also sell their products, they are exempt from import quotas and tariffs.
The Forces Driving Global Businesses
Expanding Markets
Traditional motivation: Extend the product life
cycle.
EMERGING MOTIVATION:
FIND BUYERS FOR HIGHLY
SPECIALIZED PRODUCTS.

Gaining Access Cutting

to Resources Costs
Traditional motivation: Traditional motivation:
Find raw materials. Reduce labor and
EMERGING MOTIVATION: transportation costs.
OBTAIN HUMAN EMERGING MOTIVATION:
RESOURCES. OBTAIN TARIFF
REDUCTIONS

Capitalizing on Special Features of

Location
Traditional motivation: Profit from unique local
features,
EMERGING MOTIVATION:
FOLLOW LARGE CLIENT FIRMS THAT
LOCATE ABROAD 18–23
 OPERATING ADVANTAGES &
DISADVANTAGES OF
24
MULTINATIONALS-MNCs
 MNCs have certain unique advantages and
disadvantages in their operations that make them
quite different from purely domestically oriented
companies.
 The international success of the MNCs is primarily

because of their ability to overcome the

disadvantages and capitalize on the advantages.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
251) Superior Technical Know-how
 Perhaps the most important advantage that MNCs enjoy is patented
technical know-how, which enables them to compete internationally.

 Most large MNCs have access to higher or advanced levels of

technology, which was either developed or acquired by the
corporation. Such technology is patented and held quite closely. It can
be in the areas of production, management, services, or processes.

 Widespread application of such technology gives the MNC a strong

competitive advantage in the international market, because it results
in the production of efficient, hi-tech, low-priced products and
services that command a large international market following.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
2) Large Size and Economies of Scale
26

 Most MNCs tend to be large.

 The large size confers the advantage of significant economies of scale
to MNCs.
 The high volume of production lowers per-unit fixed costs for the
company’s products, which are reflected in lower final costs.
 Competitors who produce smaller volumes of goods must price them
higher to recover higher fixed costs.
3) Lower Input Costs Due to Large Size
 The large production levels of multinationals necessitate the purchase
of inputs in commensurately large volumes.
 Bulk purchases of inputs enable MNCs to bargain for lower input
costs, and they are able to obtain substantial volume discounts.
 The lowered input costs imply less expensive and, therefore, more
competitive finished products.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
4)Ability to Access Raw Materials Overseas
27

 Many MNCs lower input and production costs by

accessing raw materials in foreign countries. In many
of these cases, MNCs supply the technology to extract
or refine the raw materials, or both.
 In addition to lowering costs, such access can give
MNCs monopolistic control over the raw materials
because they often supply technology only in exchange
for such monopolistic control. This control gives them
the opportunity to manipulate the supply of the raw
materials, or even to deny access, to the competitors
for this raw material.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
5)Ability to Shift Production Overseas
28

 MNCs relocate their production facilities overseas, thereby

taking advantage of lower costs for labor, raw materials, and
other inputs, and, often, utilizing incentives offered by host
countries.

 MNCs exploit the reduced costs achieved at these locations

by exporting lower-cost goods to foreign markets.

 Several major MNCs have set up factories in such low-cost

locations as China, India, and Mexico, to name only a few.
This advantage is unique to MNCs, and it gives them a
distinct edge over purely domestic corporations.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
6) Scale Economies in Shipment, Distribution, and Promotion Scale
29

economies
 The large volumes of freight they ship permit them to negotiate lower rates
with the shippers.

 Distribution and promotion costs are also lower for MNCs because of their
high volumes of production.

 The distributors in different countries charge lower commissions to move the

products because they are able to make substantial profits on their high
volumes.

 A similar lowering of costs accrues with promotional expenses.

 MNCs have large advertising budgets and are valuable clients for advertising
agencies and the media. Consequently, they are able to obtain cheaper rates.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
7) Brand Image and Goodwill Advantages
30

 This reputation spreads abroad through exports and

promotion, which adds to an MNC’s arsenal of potent weapons
in the form of brand image or goodwill, which it is able to use
to differentiate its own products from others in its genre.

 MNCs are able to leverage this goodwill or brand image by

standardizing their product lines in different countries and
achieving economies of scale.
 For example, Sony PlayStations do not have any special
modifications for different countries (except for voltage) and
the home-based plant churns out standardized products for
the world market.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
8) Access to Low-Cost Financing
31

 As a result of their size, MNCs require large amounts of financing, and

generally they are excellent credit risks.
 Therefore, they are the favored customers of financial institutions,
which lend to them at their best rates.
 The lower cost of financing for the MNCs adds to their competitive
strength.

 MNCs also have the advantage of access to different financial markets,

which allows them to borrow from the source offering the best deal;
the funds are then transferred internally to required locations.

 This access enables MNCs to avoid some countries’ credit rationing

and to obtain financing at costs lower than those available to their
domestic oriented competitors.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
9)Financial Flexibility
32

 MNCs also have an advantage in being able to manipulate

their profits and shift them to lower-tax locations.
 This greater financial leverage can be used to artificially lower prices
to enter new markets or to increase market shares in existing ones.

 The manipulation of profits to save taxes is generally

accomplished through transfer pricing, in which the overseas
subsidiaries are charged artificially higher prices for
products supplied to them by the parent company.

 MNCs also utilize several financial mechanisms with the

objectives of shifting profits and manipulating taxes.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
10)Information Advantages
33

 Multinationals have a global market view and are able to collect,

process, analyze, and exploit their in-depth knowledge of worldwide
markets.
 They use this knowledge to create new openings for their existing
products or to create new products for potential market niches.

 Their special knowledge is used to diversify and expand the market

coverage of their products and to design strategies to counter the
marketing efforts of their competitors. Moreover, excess production
can be sold off, as the company can quickly find new markets through
its global search-and-marketing mechanism.

 An MNC is able to gather commercial intelligence, forecast

government controls, and assess political and other risks through its
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
11)Managerial Experience and Expertise
34

 Because MNCs function simultaneously in a large number of

very different countries, they are able to assimilate a wealth of

valuable managerial experience.
 This experience provides insights into dealing with different
business situations and problems around the globe.

 MNCs also acquire expertise in different ways of approaching

business problems and can effectively apply this knowledge to
multiple locations.

 MNCs also develop expertise in multicountry operations

management as their executives gather experience working in
different countries on their way to senior management positions.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
12)Diversification of Risks
35

 The simultaneous presence of MNCs in different

countries allows them to more effectively bear the risk
of cyclic economic declines.

 Generally these cycles are not the same among

different countries. Thus, losses in one country can be
offset by gains in other countries.
 Simultaneous operations also provide considerable flexibility
to MNC operations, which enables them to diversify the
political, economic, and other risks that they face in different
countries.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
1)Business Risks
36

 MNCs have to bear several serious risks that are not

borne by companies whose operations are purely
domestic in nature.
 Since MNCs conduct business outside the borders of
their own countries, they deal with the currencies of
other countries, which renders them vulnerable to
fluctuations in exchange rates.

 Violent movements in exchange rates can wipe out the

entire profit of a particular business activity.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
2) Host-Country Regulations
37

 Operating in different countries subjects MNCs to a myriad of

host-country regulations that vary from country to country and,

in most cases, are quite different from those of the home country.

 Regulations are often changed, and such changes can have

adverse implications for MNCs. For example, a country may ban
the import of a certain raw material or restrict the availability of
bank credit. Such constraints can have serious effects on an
MNC’s production levels.

 In many developing countries, national controls are quite

pervasive and almost every facet of private business activity is
subject to government approval.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
3) Different Legal Systems
38

 MNCs must operate under the different legal systems of different

countries. In some countries the legislative and judicial processes are
extremely cumbersome and contain many nuances that are not easily
understood by non-natives.

 Some legislation can also prohibit the type of business activity the MNC
would regard as normal in its home country.
4) Political Risks
 Host countries are sovereign entities and their actions normally do not
admit any appeals. There is little that an MNC can do if a host country is
determined to take actions that are inimical or unfriendly to its interests.
 This political risk, as it is known, increases in countries whose governments are
unstable and tends to change frequently.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
5) Operational Difficulties
39

 Unwritten business practices and market conventions often prevail in

host countries.

 MNCs that lack familiarity with such conventions find it difficult to

conduct business in accordance with them. Often the normal methods
of operation of an MNC can be quite contrary to a country’s business
practices.

 A typical example is informal credit. In many countries retailers agree

to stock goods of a manufacturing company only if they are offered a
market-determined period of credit that is not covered by a written
document. The accounting and sales policies of an MNC may not
permit such arrangements.
 On the other hand, doing business in that country may not be at all
possible without such arrangements.
 OPERATING ADVANTAGES &
DISADVANTAGES OF-MNCs
6) Cultural Differences
40

 Cultural differences often lead to major problems for MNCs.

 Many find that their expatriate executives are not able to turn in
optimal performances because they are not able to adjust to the
local culture, both personally as well as professionally. On the
other hand, local managers of MNCs often have difficulties in
dealing with the home office of an MNC because of culturally
based communication problems.

 Inability to understand and respond appropriately to local cultures

has often led MNC products to fail. Misunderstanding of local
cultures, work ethics, and social norms often leads to problems
between MNCs and their local customers, their business
associates, government officials, and even their own employees
41

Domestic Companies Vs MNCs

42
Methods of going global

Locating
Exporting
facilities abroad

Metho
International
ds of
strategic Importing
alliances going
global

International Foreign
franchising licensing

18–43
44
 Methods of going global

1) Exporting
 Selling products produced in the home country to customers
in another country.
 Low-cost way to expand into international markets
 Ease of selling on the Web has fueled export activity.
 Exporting Challenges

 Communicating in a foreign language

 International shipping

 Product modification

 Governmental regulations and relations

 Currency exchange rates and payment methods

18–45
 Methods of going global (cont.)
2) Importing
 Selling goods produced in another country to buyers in
the home country.
 Success requires finding a good product vendor.

3) Global Sourcing Strategy

 Connecting with overseas suppliers that can provide
products or services
a firm needs to operate successfully.

18–46
 Strategy Options for Global Firms (cont.)

4) Foreign Licensing
 Allowing a firm in another country to purchase the
right to manufacture and sell a firm’s products in
international markets.
Licensee—the company buying the licensing rights
Licensor—the company selling the licensing rights
 Royalties
Fees paid by the licensee to the licensor for each
unit produced under a licensing contract
 Counterfeit activity
18–47
 Methods of going global (cont.)
5) International Franchising
 Selling a standard package of products, systems, and
management services to a firm in another country.
6) International Strategic Alliances
 A combination of efforts and/or assets of firm in different
countries for the sake of pooling resources and sharing the
risks of an enterprise.

 are a particular subset of cooperative agreements, which

have a significant strategic element to them.

 are inter-firm cooperative agreements which are intended

to affect the long-term product-market positioning of at
least one partner. 18–48
49
 Methods of going global (cont’d)
7) Locating Facilities Abroad-FDI
 Cross-border acquisition
The purchase by a business in one country of a
company located in another country
 Greenfield venture
investment involves the establishment of a
completely new business unit in a foreign market.
A wholly owned subsidiary formed “from scratch”
in another country

18–50
 1.4. Other International Players

International Banks
 Major banks operate internationally to service their MNC

clients.
 The globalization of business is well expressed in the

banking sector: Citibank

 Cross-border mergers have also created a few top global

asset management firms: U.S.-based Blackrock

 The emergence of more consolidated financial institutions at

the global level is a recent phenomenon - deregulation.

The International Monetary Fund (IMF)

 The IMF is an international organization of 189 member

countries, based in Washington, DC, which was conceived
at a United Nations conference convened in Bretton Woods,
New Hampshire, in 1944.
 The 45 governments represented at that conference sought
to build a framework for economic cooperation that would
avoid a repetition of the disastrous economic policies that
had contributed to the Great Depression of the 1930s.
 The main goals of the IMF are to ensure the stability of
the international monetary and financial system, to help
resolve crises when they occur, and to promote growth and
alleviate poverty.
 IMF……

 Technical assistance and training are offered to help

member countries strengthen their capacity to design and
implement effective policies.
 Economic crises often occur when countries borrow
excessively from foreign lenders and subsequently
experience difficulties financing their balance of payments.
 The IMF is set up to offer temporary financial assistance to
give member countries the breathing room they need to
correct balance-of-payment problems.
 The World Bank

 Created in 1944, as the International Bank for

Reconstruction and Development (IBRD), to facilitate
postwar reconstruction and development.
 Over time, the IBRD’s focus shifted toward poverty
reduction, and in 1960, the International Development
Association (IDA) was established.
 Whereas the IBRD focuses on middle-income countries, the
IDA focuses on the poorest countries in the world.
 Together they provide low-interest loans, interest-free
credits, and grants to developing countries for investments
in education, health, infrastructure, communications, and
other activities.
 The World Bank

 The WB also provides advisory services to developing

countries and is actively involved with efforts to reduce and
cancel the international debt of the poorest countries.
 The WB is an important borrower in international capital
markets it then lends these funds to developing countries at
a small markup.
 Its five agencies (WB Groups) are:
 International Bank for Reconstruction and Development (IBRD)
 International Development Association (IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency (MIGA)
 International Centre for Settlement of Investment Disputes (ICSID)
 Multilateral Development Banks (MDBs)

 These institutions provide financial support and professional

advice for economic and social development activities.
 The term typically refers to the World Bank Group and four
regional development banks: the African Development
Bank, the Asian Development Bank, the European Bank for
Reconstruction and Development, and the Inter-American
Development Bank.
 These banks have a broad membership that includes both
developing countries (borrowers) and developed countries
(donors), and their membership is not limited to countries
from the region of the regional development bank.
The World Trade Organization (WTO)
 In 1995, the GATT members created the WTO,
headquartered in Geneva, Switzerland.
 Whereas GATT was a set of rules, the WTO is an
institutional body.
 The WTO expanded its scope from traded goods to trade
within the service sector and intellectual property rights.
 Various WTO agreements set the legal ground rules for
international commerce to hopefully ensure that the
multilateral trading system operates smoothly.
 The Organization for Economic Cooperation and
Development (OECD)

 The OECD operates from Paris, France, and is a group of 36

relatively rich member countries founded in 1961.
 It provides a setting to examine, devise, and coordinate
policies that foster sustainable economic growth and
employment, rising standards of living, and financial
stability in member countries and beyond.
 Analysis by the OECD staff and representatives of the
member countries in specialized committees may culminate
in formal agreements or treaties between member countries.
 The Bank for International Settlements
(BIS)
 Established in 1930, fosters international monetary and
financial cooperation to promote stability and serves as a
bank for central banks, 60 central banks.

 Bimonthly meetings of the governors and other senior

officials of the BIS member central banks to discuss
monetary and financial matters are instrumental in pursuing
this goal.

 BIS standing committees support central banks and

authorities in charge of financial stability more generally, by
 The European Union (EU)

 The member states of the EU seek to create a common

market in which goods, services, people, and capital can
move around freely and to achieve economic and political
integration.

 In 1992, the EU decided to go for economic and monetary

union (EMU) , involving the introduction of a single
European currency managed by a European central bank.

 28 member states
 Governments

 Governments are important players in international financial

management because they set the regulatory environment in
which multinationals operate.

 Governments (central banks in particular) also affect

important asset prices, such as interest rates, which
constitute the main component of a firm’s cost of debt.
 Others

 Individual and Institutional Investors

 Sovereign Wealth Funds
 Hedge Funds and Private Equity Firms
 A hedge fund is a pooled investment fund that holds
liquid assets and that makes use of complex trading and
risk management techniques to improve investment
performance and insulate returns from market risk.
Among these portfolio techniques are short selling and the
use of leverage and derivative instruments.

END OF THE CHAPTER