Introduction to International Finance: Scope and Features

8/14/2019 Introduction to International Finance: Scope and Features

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(ii) Why Companies Engage in International Business.[Common

Theories/Explanations/Hypotheses]

x Theory of Comparative Advantage (Classical Trade Theory).x Imperfect Market Theory (Theory of Factor Endowments).

x The Product Cycle Theory

x Internalization Theoryx Other Motives - Portfolio Theory, Oligopoly Model,

Strategic Motives, Behavioral Motives.

x A Synthesis of Theories: The Eclectic Theory (OLI).

(iii) The Evolution of International Financial Markets.

(IV) The Global Financial System and the Global

Financial Manager. 2


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The Scope of International FinanceThree conceptually distinct but interrelated parts are

identifiable in international finance:

International Financial Economics: concerned withcauses and effects of financial flows among nations -application of macroeconomic theory and policy to theglobal economy.

International Financial Management: concerned with howindividual economic units, especially MNCs, cope withthe complex financial environment of internationalbusiness. Focuses on issues most relevant for making

sound business decision in a global economy. International Financial Markets: concerned with

international financial/investment instruments, foreignexchange markets, international banking, international

securities markets, financial derivatives, etc. 3


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Distinguishing Features of International Finance:

Arbitrage:

3 Purchase of securities or commodities in one market forimmediate resale in another to profit from a pricediscrepancy.

3 Tax Arbitrage: shifting of gains or losses from one taxjurisdiction to another in order to profit from differencesin tax rates.

3

Risk Arbitrage: the process which ensures that, inequilibrium, risk-adjusted returns on different securitiesare equal, unless market imperfections hinder theadjustment process.

The process of arbitrage ensures market efficiency.4


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Market Efficiency

Weak-form Efficient: historical information pluscurrent information are reflected in today's prices.

Semi-strong-form Efficient: all relevant public

information is reflected in today's prices.

Strong-form Efficient: all relevant public and

private (insider) information is reflected.It is not possible to test this because private

information is not available.

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CAPM & ICAPM CAPM: specifies the relationship between risk and

required rates of return on assets held in well-diversified

portfolios. The model rests on a set of assumptions that

are very restrictive. The basic model is given by:

Kx = KRf + x ( Km - KRf )

The CAPM assumes that the total variability (total risk)

of an asset's returns include systematic and unsystematic.

Unsystematic risk is diversifiable while systematic risk is

priced (investors are compensated for bearing this risk).

The implication of considering a "global market" rather

than "national market" on traditional CAPM will be

explored by examining ICAPM. 6


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The Arbitrage Pricing Theory

3 The APT is a multi-factor equilibrium pricing

model more general than the CAPM.It assumes that

the return on a security is a linear function of a numberof systematic factors rather than a single factor as in

the case of CAPM.3 Factors expected to have an impact on all assets:

- Inflation

- GDP/GNP Growth- Major Political Developments

- Interest Rates

- And Much More 7


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3 Exchange Risk: the risk of loss from unexpectedchanges in the exchange rates.

3 Political Risk: the risk of loss from unforeseengovernment action or other political/environmentalevents e.g., riots, acts of terrorism, etc.

International Finance exploits the fact macroeconomicfluctuations among nations are less uniform than thoseamong regions of the same country.

3 National governments still conduct macroeconomicpolicies with considerable autonomy - price levels,

interest rates, real income, and employment tend to varymore across countries than within a country.

3 Hence risk reduction opportunities exist throughinternational diversification - especially into emerging

markets. 8


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International Finance deals with the consequences of

profound differences in national laws, institutionalized

business policies, cultural environment, tax systems etc,

and the implications for arbitrage, FDI, transfer pricing,and other operational policies.

International Financial/Investment Instruments:

Survey of instruments, comparison of performances,

exploration of optimal combination of securities for

superior risk/reward tradeoff.

The subject matter of International Finance is extensive inscope and can be technically challenging, but it is both

intellectually stimulating and offers rich rewards.

It is perhaps fair to say to the international/global

financial manager: don't leave home without it." 9


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Motivation For Overseas Expansion

Why do Firms Expand Internationally?

Common Explanations Include:

1) Theory of Comparative Advantage:

(the classical theory of international trade first developedby Adam Smith and David Ricardo)

3 Theory argues that each country should specialize in the

production and export of those goods it can produce

with relative efficiency.3 Underlying this theory is the assumption that goods and

services can move internationally but factors (land,

labor, and capital) are relatively immobile.10


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3 Classical trade theory, however, is becomingincreasingly irrelevant in todays global businessenvironment where differences among corporations

are becoming more important than aggregatedifferences among countries.

3 Today, the increasing capacity of even small

companies to operate on a global scale makes theclassical framework all the more obsolete.

3 Major developed economies are now more

homogeneous than before in terms of living standards,life styles, and economic institutions and their factorsof production move rapidly across borders in searchof higher returns.

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3Natural resources have lost part of their previous role

in national specialization as advanced, knowledge-

based economies have moved into the age of synthetic

materials and genetic engineering.

3 Technological know-how has become a global pool with

U.S. MNCs outsourcing software development, callcenters, accounting, engineering, manufacturing, and

other services to India, China, Mexico, and Brazil.

3 As a result of rapid development in the technology ofcommunication, duplication, reproduction, and storage of

information, companies can now trade education, skills,

and other factors internationally. 13


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3 Therefore, contrary to the classical theory, the very

existence of many multinational enterprises is based

on the international mobility of certain factors ofproduction (capital, technology, entrepreneurship)

3 Information technology makes it possible for worker

skills to flow with little regard to borders.

3 Contemporary global economy is moving away

from a system in which products are made in one

country and exported to others to one in which valueis added in several different countries depending on

advantages in labor costs and unique national

attributes or skills. 14


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2) Imperfect Market Theory:

3 Countries differ with respect to their resource

endowments.3 Resources are somewhat immobile and firms must

sometimes seek out these resources.

In a world of perfect markets, the followingconditions will hold:

Zero information cost = free flow of informationacross countries.

Zero cost of labor mobility. Zero transportation costs.

Zero cost of transferring funds.

One global currency (no currencyrisk). 15


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3 If all these assumptions hold, there will be a reduced

incentive to establish certain types of subsidiaries

overseas.

3 In reality there are costs and often restrictions on the

transfer of resources across countries.

Firms move to other countries to take advantage ofthe availability of certain resources.

3 However it is also true today that the existence of

MNC rests on international mobility of certain

factors of production - capital, technology, etc.

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3) The Product Cycle:3 Suggests that direct foreign investment is a natural

stage in the life cycle of a new product from itsinception to its maturity and possible eventualdecline.

3 New, technologically advanced, or differentiated,

products are discovered/launched typically in anadvanced industrial country (e.g. U.S., UK, or Japan)

New products, e.g., high definition televisions, arefirst introduced in a "home market."

3 Close coordination of production and sales arerequired while product is improved, and

production process standardized.17


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3 After a short time lag the product is exported.As the new product reaches maturity, competition

from nearly identical products narrows profit

margins and threatens both export and the homemarket.

3 At this stage, defensive foreign manufacturinglocations are sought where market imperfectionsin the cost of factors of production create a chancefor lower unit production costs.

3 Product differentiation is a common strategy toprolong the demand (foreign) for the products.

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Two fundamental tenets of the product life cycle

hypothesis are technology and the market.

3 Technology: as a critical component of both productdevelopment and production.

3 The Market: size and structure of the international

market are increasingly becoming critical factors in thedetermination of trade and investment patterns.

3 International product life cycle theory traces the

roles of innovation, market expansion, comparative

advantage, and strategic responses of global rivals

in international production, trade, and investment

decisions. 19


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Internalization:3 Is the extension of ownership by a firm to cover new

markets, new sources of material, and new stages ofthe production process.

3 It covers horizontal and vertical integration, purchase

of labor (specialized labor), capital and technology.

Firm also internalizes R&D.

3 The concept of appropriability implies that organizationswhich possess a unique body of know-how will attemptto avoid dissipation of this know-how to third parties.

3 Proprietary firm-specific advantages yield economicrents when exploited on a world-wide basis.

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Externalization

Is an alternative strategy for utilizing proprietary

technology.

It involves contracting with other firms under

licensing agreements, management contracts, or

other income-producing arrangements that involvethe sale of the technology rather than the sale of

the products of the technology.

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5) Other Motives for Overseas Expansion

Portfolio Theory: Rests on two essential variables

of risk and return.Risk is a measure of the variability of returnsassociated with an investment.

3 Investors are generally risk averse.Portfolio theory shows that in many situations therisk of individual projects tend to offset oneanother.

3 The key element in portfolio theory is thecorrelation coefficient between securities in the

portfolio. 22


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3 When securities with low degrees of correlationare combined in a portfolio, the risk of theportfolio is less than the sum of the risks of the

individual components.

3 Since domestic and foreign economic cycles arenot perfectly synchronized, their securities tend to

be less correlated with one another compared topurely domestic securities.

3 International investment may therefore be

motivated by the opportunities for superior risk-return tradeoff through internationaldiversification.

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Oligopoly Model:

3 Posits that firms expand overseas to exploit their

quasi-monopoly advantages - e.g., access tocapital, possession of differentiated products,

technology, and superior management.

3 Horizontal investments abroad are made to expanda firms operation or to reduce the number of

competitors.

3 Vertical investments abroad are made to raise

barriers to entry for new competitors, and to

protect oligopoly positions.24


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Strategic Motives:

Foreign expansion can be motivated by a host of

"strategic" considerations including: Expansion to New Markets

Raw Material Seekers

Knowledge Seekers Production Efficiency Seekers

Bandwagon Effect - follow the leader strategy

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Behavioral Considerations: Foreign expansion

may be motivated by behavioral considerations.

3

A dominant individual or individuals may havepersonal preferences for a particular foreign location

-- ego, commitment, dream, "ancestral pull," to give

something back, family commitment, etc.

6) A Synthesis:

3 Motives for overseas expansion are too closely

interrelated to be considered separately - they are notmutually exclusive.

3 The Eclectic Model attempts to synthesize some of

the theories. 26


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The Eclectic Approach: (Dunning 1979, 1981):

Explains why MNC make FDI decisions based on

integrated analysis of several factors including: -Competitive advantage - Preference for FDI and -

Selection of best geographic location.

It argues that "specific-location" advantages favor ahost country while "specific-ownership" advantages

favor the investing firm.

A combination of advantages for both company and

host country is necessary for international expansion.

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Evolution of International Financial Markets

3 In recent years, financial markets have becomeintegrated in many respects.

3 Investors in the various "national" financial

markets take advantage of global financial market

imperfections (transaction costs, taxes, tariffs,

quotas, labor immobility, cultural differences,

financial reporting differences, etc.).

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3 Some of the motives for investors to penetrateforeign financial markets include:

Motives for International Investments:- Why investors invest in foreign markets?- Why creditors provide credit in foreign markets?

Economic conditions, exchange rate expectations,

international diversification, differential interest rates.

Motives for Firms to Obtain Funds from ForeignMarkets: i.e., borrowing in foreign markets and selling

securities in foreign markets.Differential interest rates, exchange rate expectations,

greater excess to funds, lower price sensitivity to local

conditions.29


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Instruments that Facilitate International Transactions

Forwards, Futures, Options, and Swaps. They facilitate cross-border transactions by:

- Reducing cost

- Reducing exchange rate risks- Reducing interest rate risks

- Redistributing risk among parties

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The Global Financial System and the Global

Financial Manager

3 In a world of global markets rather than national

or local markets, the global financial manager

wears many hats.

3 He/she combines the knowledge of product or

service; sources of "raw" materials and other

resources; alternatives to these inputs; diversifiedfunding sources; changing relative values of the

various factors and political and economic

choices and innovations in key nations. 31


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3 He/she is a global scanner, and a global thinker.

The global financial manager is able to shift

resources/factors/profits among affiliates throughtransfer pricing on goods and services traded

internally, dividend payments, inter-company

loans, leading/lagging inter-company payments,

fees and royalty charges.

3 He/she has the ability to circumvent exchange

controls and other regulations, tap previouslyinaccessible investment and financing

opportunities, and exploit tax differentials across

markets.and more!32


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General Economic News and Information

x The Economist

x The Financial Timesx The Wall Street Journal

x The New York Times

xNews Link

x CNN Financial Network

x Business Week

x The Washington Post

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http://www.economist.com/http://www.ft.com/http://wsj.com/http://nytimes.com/http://www.newslink.org/http://www.cnnfn.com/http://www.businessweek.com/http://www.washingtonpost.com/http://www.washingtonpost.com/http://www.businessweek.com/http://www.cnnfn.com/http://www.newslink.org/http://nytimes.com/http://wsj.com/http://www.ft.com/http://www.economist.com/

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Introduction to International Finance: Scope and Features

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