MODULE-1

International financial Environment

International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
Page 5
The Importance, rewards & risk of international finance- Goals of MNC- International
Business methods

Exposure to international risk- International Monetary system-
Multilateral financial institution
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International finance (also referred to as international monetary economics or international
macroeconomics) is the branch of financial economics broadly concerned with monetary and
macroeconomic interrelations between two or more countries. International finance examines the
dynamics of the global financial system, international monetary systems, balance of payments,
exchange rates, foreign direct investment, and how these topics relate to international trade.
Sometimes referred to as multinational finance, international finance is additionally concerned
with matters of international financial management. Investors and multinational corporations
must assess and manage international risks such as political risk and foreign exchange risk,
including transaction exposure, economic exposure, and translation exposure.
Some examples of key concepts within international finance are the Mundell

Fleming model,
the optimum currency area theory, purchasing power parity, interest rate parity, and the
international Fisher effect. Whereas the study of international trade makes use of mostly
microeconomic concepts, international finance research investigates predominantly
macroeconomic concepts.
International financial management also known as international finance is a popular concept
which means management of finance in an international business environment, it implies, doing
of trade and making money through the exchange of foreign currency.[1] The international
financial activities help the organizations to connect with international dealings with overseas
business partners- customers, suppliers, lenders etc. It is also used by government organization
and non-profit institutions.
International financial Environment
-
The Importance
Compared to national financial markets international markets have a different shape and
analytics. Proper management of international finances can help the organization in
achieving same efficiency and effectiveness in all markets, hence without IFM sustaining
in the market can be difficult.
Companies are motivated to invest capital in abroad for the following reasons

Efficiently
produce products in foreign markets than that domestically.

Obtain the essential raw materials needed for production.
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
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Broaden markets and diversify

Earn higher returns
Whats Special about International Finance
?
1.
Foreign exchange risk
a.
E.g., an unexpected
devaluation adversely affects your export market...
2.
Political risk
a.
E.g., an unexpected overturn of the government that jeopardizes existing
negotiated contracts...
3.
Market imperfections
a.
E.g., trade barriers and tax incentives may affect location of production...
4.
Expanded opportunity sets
a.
E.g., raise funds in global markets, gains from economies of scale...
Rewards & risk of international finance
International financial markets face a variety of risks and they are collectively known
as
international finance risks
. T
he premier financial institutions of the world apply various
principles and practical applications to deal with the risks of international finance. Financial risks
usually are those kind of risks which are related to finance or money. The financial risks related
to investments include capital risk, currency risk, as well as liquidity risk. The debt related risks
include interest rate risk and credit risk.
The international insurance industry also faces a number of risks.
The various risks that influence
international financial markets usually include the following:

Political risk

Financial risk

Economic risk

Country risk

Market risk
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
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Exchange rate risk

Operational risk

Legal risk

Hedging risk

Systemic risk
The international financial market has experienced a significant shift in the 1980s and 1990s.
The international financial transactions have become more complicated and rapid and as a result
of this, the international financial markets are facing greater uncertainties. Currently, the
financial services industry has become much more aggressive and the international market
participants are getting the exposure to increased financial risks than earlier. The reasons behind
this
are:
The globalization of financial markets

The unpredictability or volatility of the international financial markets

The complex structure of the new types of investments

The increase in the global supply of loanable funds

The intense international market competition, which is increasing day by day
Hence, it is absolutely necessary that the financial risks are properly measured and preventive
actions for efficient management of international financial risks are applied. For maintaining the
stability of both international financial market and domestic financial market, the performance of
efficient risk management by banks and financial institutions is crucial. Supply of accurate and
reliable information on international financial markets is important for the market participants
because with help of dependable information, they are able to make knowledgeable investment
decisions.
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.
These different changes are themselves related.
For example, declining exchange rates tend to
be associated with relatively high interest rates and inflation.
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.
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.
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
Page 8
Instead, the amount of exposure and risk depends crucially on the way exchange rates and other
financial prices are connected.
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.
International finance is not just finance with an extra cause of
uncertainty.
It is a legitimate subject of its own, with its own risks and ways of managing them.
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
ties to exchange rates and other developments in the increasingly integrated,
global financial environment.
Multinational corporations
(MNCs) are defined as firms that engage in some form of international business. Their managers
conduct international financial management, which involves international investing and
financing decisions that are intended to maximize the value of the MNC. The goal of their
managers is to maximize the value of the firm, which is similar to the goal of managers
employed by domestic companies. Initially, firms may merely attempt to export products to a
particular country or import supplies from a foreign manufacturer. Over time, however, many of
them recognize additional foreign opportunities and eventually establish subsidiaries in foreign
countries. Dow Chemical, IBM,Nike, and many other firms have more than half of their assets in
foreign countries. Some businesses, such as ExxonMobil, Fortune Brands, and Colgate-
Palmolive, commonly generate more than half of their sales in foreign countries. Even smaller
U.S. firms commonly generate more than 20 percent of their sales in foreign markets, including
Ferro (Ohio), and Medtronic (Minnesota). Seventy-five percent of U.S. firms that export have
fewer than 100 employees.
International financial management is important even to companies that have no
international business because these companies must recognize how their foreign competitors
will be affected by movements in exchange rates, foreign interest rates, labor costs, and inflation.
Such economic characteristics can affect the foreign competitors

costs of production and
pricing policies.
Goals of MNC
The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers
employed by the MNC are expected to make decisions that will maximize the stock price and
therefore serve the shareholders. Some publicly traded MNCs based outside the United States
may have additional goals, such as satisfying their respective governments, creditors, or
employees. However, these MNCs now place more emphasis on satisfying shareholders so that
they can more easily obtain funds from shareholders to support their operations. Even in
developing countries such as Bulgaria and Vietnam that have only recently encouraged the
development of business enterprise, managers of firms must serve shareholder interests so that
International Financial Management
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Department of M
BA
, SJBIT
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they can obtain funds from them. If firms announced that they were going to issue stock so that
they could use the proceeds to pay excessive salaries to managers or invest in unprofitable
business projects, they would not attract demand for their stock. The focus in this text is on the
U.S.-based MNC and its shareholders, but the concepts commonly apply to MNCs based in other
countries.
The focus of this text is on MNCs whose parents wholly own any foreign subsidiaries, which
means that the U.S. parent is the sole owner of the subsidiaries. This is the most common form of
ownership of U.S.-based MNCs, and it enables financial managers throughout the MNC to have
a single goal of maximizing the value of the entire MNC instead of maximizing the value of any
particular foreign subsidiary.
International Finance: Benefits
Some of the benefits of international finance are:

Access to capital markets across the
world enables a country to borrow during tough
times and lend during good times.

It promotes domestic investment and growth through capital import.

Worldwide cash flows can exert a corrective force against bad government policies.

It prevents excessive domestic regulation through global financial institutions.

International finance leads to healthy competition and, hence, a more effective banking
system.

It provides information on the vital areas of investments and leads to effective capital
allocation.
In
ternational finance promotes the integration of economies, facilitating the easy flow of capital.
The free transfer of fundswould eventually result in more equality among countries that are a
part of the global financial system.
International Business methods
1.
Exporting
Is the selling of products to a foreign country or countries.
Advantages:
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
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Involves less financial risk

Little cost or investment associated with the exception of establishing distribution
networks or local advertising

Allows business to enter the global market gradually

Agents are used as they have better understanding of local markets n assist in the
marketing strategies
Disadvantages:

Loss of control over the product once it has been sold to the distributor or agent

Lack of unde
rstanding of the firms history and product range
Types are:

Direct

this involves a business selling directly to an overseas buyer (not really the end
user). They use their own sales representatives based in foreign markets or agents

Indirect

is where business's use intermediaries to get their products into overseas
markets. Adv is that its easy and inexpensive and using the agents experience. Disad is
that the agents may be handling more than one customer so negligence can occur and
ending contracts can be a very expensive and time consuming process.
2.
Foreign Direct Investment (FDI)
Its investment that gains control of foreign assets or businesses. Method of international
expansion that gets controlling interest in property, assets or companies in other countries.
Involves higher commitment as it usually involves a transfer of money, personnel and
technology.
Methods of FDI:
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
Page
11
3.
Relocation of Production
Important factors to consider are:

Cost and availability

labour and raw materials

Political stability

Economic development
Reasons for relocating production overseas are:

Reduce labour costs

take adv of lower wages and raw materials

Get around trade barriers

doing this business can be consequently protected from
foreign competition

To be closer to customers

reduces transportation costs/ respond quickly to changes in
demand
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
Page
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4.
Management Contracts

These are agreements where one business provides managerial assistance, technical
expertise to another organisation for a certain period of time
Advantages for business receiving assistance are:

Good for developing nations

Obtain skilled labour

without increased foreign investment
Advantages for business providing services:

Get a flat fee or % of sales

Extra income with little cash
outlay

Exposure to a foreign market
5.
Licensing
Licensing
is an agreement where a licensor, grants the licensee the right to use its patent,
copyright or brand name.
Advantages for licensee are:

Has right to use a proven design

costs less than developing own
Advantages for licensor:

Take advantage of foreign production without any ownership or investment obligations

Learn about a new market without investing a lot time and effort

Can overcome problem of limited resources for establishing production internationally
Disadvatanges are:

Loss of control over asset including quality standards and distribution

Licensing of technology can create a future competitor

Licensee can learn the secrets and use the knowledge for own operations
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
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6.
Franchising
Franchising is the same as licensing in that the franchiser allows the franchisee to use the
trademark or brand or reputation.
It different from licensing because:

Franchisers provide ongoing support to the franchisees including management training,
business advice and advertising

Franchisers have more control over the sales of its products

Used in service industry such as hotels, restaurants and real estate
Advantages are:

Low cost, low risk way of entering new markets (franchiser)

Ability to maintain product consistency by duplicating processes around the world (sers)

Have access to cultural knowledge of local managers (sers)

Get well known and proven products, operating systems and brand names (sees)

Can often have deals arranged with suppliers, reducing costs for production (sees)
Disadvantages are:

Difficulty in managing a large no of stores around the world

Actions of either party affect the other

Franchisees dont have much flexibility
7.
Acquisitions of existing operations
Firms frequently acquire other firms in foreign countries as a means of penetrating foreign
markets. Acquisitions allow firms to have full control over their foreign businesses and to
quickly obtain a large portion of foreign market share.
EXAMPLE
Cadbury Schweppes has grown mainly through acquisitions in recent years including
Wedel chocolate (Poland, 1999), Hollywood chewing gum (France, 2000), a buyout of
minority shareholders of Cadbury India (2002), Dandy chewing gum from Denmark
(2002) and the Adams chewing gum business ($4.2 bn, 2003). Clearly they were seeking
synergies by being dominant in the chewing gum business. Then in early 2010 Cadbury
Schweppes were taken over by Kraft Foods to create a 'global confectionery leader'.
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
Page
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An acquisition of an existing corporation is a quick way to grow. An MNC that grows in this
way also partly protects itself from adverse actions from the host government of the acquired
company. The MNC has control of a usually well-established firm with good connections to its
government. The risk is that too much has been paid for the acquisition, also that there are
unforeseen problems with the acquired company. It has to be remembered that the sellers of the
company have a thorough knowledge of the business and the price at which they are selling is
presumably higher than their estimate. The acquiring company is therefore to a certain extent
outguessing the local owners -
a risky proposition.
Some firms engage in partial international acquisitions in order to obtain a stake in foreign
operations. This requires a smaller investment than full international acquisitions and therefore
exposes the firm to less risk. On the other hand, the firm will not have complete control over
foreign operations that are only partially acquired.
8.
Establishing new
foreign subsidiaries
Firms can also penetrate foreign markets by establishing new operations in foreign countries to
produce and sell their products. Like a foreign acquisition, this method requires a large
investment. Establishing new subsidiaries may be preferred to foreign acquisitions because the
operations can be tailored exactly to the firm's needs. Development will be slower, however, in
that the firm will not reap any rewards from the investment until the subsidiary is built and a
customer base established.
Exposure to international risk
1.
Exposure to International Economic Conditions.
The amount of consumption in any country is influenced by the income earned by consumers in
that country. If economic conditions weaken, the income of consumers becomes relatively low,
consumer purchases of products decline, and an MNC s sales in that country may be lower than
ex
-
pected. This results in a reduction in the MNCs cash flows, and therefore in its value.
Example:
In October 2008, the credit crisis intensified. Investors were concerned that the economic
conditions in the United States and in many other countries would deteriorate. This resulted in
expectations of a reduced demand for exports produced by U.S. firms. In addition, it resulted in
expectations of reduced earnings of foreign subsidiaries (because of a reduced local demand for
the subsidiary s products), and therefore a reduction in remitted earnings to the MNC s parent.
These revised expectations reflected a reduction in cash flows to be received by the parent, and
therefore caused reduced valuations of MNCs. Stock prices of many U.S.-based MNCs declined
by more than 20 percent during the October 6

10 period in 2008
International Financial Management
12MBAFM426
Department of M
BA
, SJBIT
Page
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2.Exposure to International Political Risk.
Political risk in any country can affect the level of an MNCs sales. A foreign government may
increase taxes or impose barriers on the MNC s subsidiary. Alternatively, consumers in a foreign
country may boycott the MNC if there is friction between the government of their country and
the MNC s home country. Political actions like these can reduce the cash flows of the MNC.
3.Exposure to Exchange Rate Risk.
If the foreign currencies to be received by aU.S.-based MNC suddenly weaken against the dollar,
the MNC will receive a lower amount of dollar cash flows than was expected. This may reduce
the cash flows of the MNC.
Example:
Missouri Co. has a foreign subsidiary in Canada that generates earnings (in Canadian dollars)
each year. Before the subsidiary remits earnings to the parent, it converts Canadian dollars to
U.S. dollars. The managers of Missouri expect that because of a recent government policy in
Canada, the Canadian dollar will weaken substantially against the U.S. dollar over time. Conse-
quently, the expected U.S. dollar cash flows to be received by the parent are reduced, so the
valuation of Missouri Co. is reduced
Many MNCs have cash outflows in one or more foreign currencies because they import supplies
or materials from companies in other countries. When an MNC has future cash outflows in
foreign currencies, it is exposed to exchange rate movements, but in the opposite direction. If
these foreign currencies strengthen, the MNC will need a larger amount of dollars to obtain the
foreign currencies that it needs to make its payments. T
his reduces the MNC s dollar cash flows
(on a net basis) overall, and therefore reduces its value.
4. Uncertainty of an MNCs Cost of Capital
An MNC s cost of capital is influenced by the return required by its investors. If there is
suddenly more uncertainty surrounding its future cash flows, investors may only be willing to
invest in the MNC if they can expect to receive a higher rate of return. Consequently, the higher
level of uncertainty increases the return on investment required by investors (which reflects an
increase in the MNC s cost of obtaining capital), and the MNC s valuation d