International Finance Overview

Overview of International Finance Study

• International Finance is critical for understanding the interconnected world economy
• Studying international finance involves understanding specialized aspects
• International financial management aims to achieve specific goals
• Crucial elements include the globalization of the world economy
• Multinational corporations (MNCs) play a significant role

Why Study International Finance?

• The world economy is highly globalized and integrated
• Markets for both goods/services and financial assets are integrated
• Major economic functions like consumption, production, and investment are globalized

What’s Special about International Finance?

• International finance differs from domestic finance in four dimensions
• Foreign exchange risk which includes exchange rate uncertainty is a key factor
• Political risks are also a key risk, as sovereign nations can change the "rules"
• Market imperfections can impede movements of goods, services, and capital
• International finance provides an expanded opportunity set

Foreign Exchange Risk

• Foreign exchange risk arises from unpredictable exchange rates
• Profits in a foreign currency can be affected when converted due to exchange rate movements
• Major currencies fluctuate unpredictably: U.S. dollar, Japanese yen, British pound, and euro
• All major economic functions are greatly influenced by exchange rate uncertainty
• Fixed exchange rates were abandoned in the early 1970s

Foreign Exchange Risk Example

• Example demonstrates foreign exchange risk with a Toyota share investment
• Initial investment: $1,000 converted to ¥100,000 to buy 50 Toyota shares at ¥2,000 each
• A 10% increase in share price results in an investment worth ¥110,000
• If the yen depreciates to $1 = ¥120, the investment's dollar value becomes $916.67
• Yen depreciation leads to financial loss, despite Toyota's share price increasing

Political Risk

• Political risk arises when a country changes the "rules of the game"
• Affected parties may have limited recourse
• MNCs and international investors face political risks when operating abroad
• Tax rule changes or expropriation of assets are examples of political risks
• Such risks are especially relevant in countries lacking a strong rule of law

Market Imperfections

• Market imperfections are frictions hindering free movement across borders
• They prevent perfect market functions
• Legal restrictions, transaction costs, and information asymmetry count a market imperfections
• Discriminatory taxation is also a key market imperfection
• These motivate MNCs to locate production overseas
• Restricting investors from diversifying their portfolios, impacts global markets

Market Imperfections: Nestlé Example

• Nestlé issued bearer shares (for foreigners) and registered shares (for Swiss)
• Foreigners could only hold bearer shares, Swiss residents could buy registered shares
• Bearer shares cost more than registered shares
• On November 18, 1988, restrictions were lifted allowing foreigners to hold registered shares
• The price difference between share types decreased

Expanded Opportunity Set

• Firms and investors can benefit from an expanded opportunity set in global markets
• Firms can boost their performance (economies of scale), or reduce capital costs globally
• Investors benefit when they diversify and lower risk, or pursue higher returns

Goals for International Financial Management

• Financial managers maximize benefits from global opportunities
• This involves controlling risk and navigating market imperfections
• The fundamental goal is shareholder wealth maximization
• This is accepted to be the goal in U.S., U.K., Australia, and Canada

Goals for International Financial Management (2)

• In Continental Europe (France, Germany), shareholders are not the only key stakeholders being considered
• Stakeholders such as employees, suppliers, customers, and banks are also measured
• In Japan, maximizing the value and growth of the keiretsu is the goal of managers
• Keiretsu are a family of firms to which individual firms belong

Corporate Governance

• Managers may prioritize personal interests over shareholders with weak monitoring
• This "agency problem" is a major weakness in a public corporation
• Corporate governance is the financial and legal framework between shareholders and the firm
• Corporate governance suffers when legal protection of shareholders is weak

Globalization: Major Trends and Developments

• Emergence of Globalized Financial Markets
• Multinational Corporations
• Privatization
• Trade Liberalization and Economic Integration

Emergence of Globalized Financial Markets

• Deregulation of markets and tech is important
• Financial innovation through currency futures, multi-currency bonds, cross border stock listings are also critical for emergence

Multinational Corporations

• MNCs are firms incorporated in one country and operating in others

• MNCs benefit from spreading R&D and advertising costs

• Utilizing tech to minimize added costs also counts

• Accessing underpriced labor is an aspect of economies of scale in certain countries.

Privatization

• Privatization involves a country divesting business ownership to the market
• Described also as a denationalization process.
• Selling state-owned businesses brings foreign reserves to the national treasury
• Often a solution for bureaucracy, waste and inefficiency
• Some estimate efficiency and reduced operating costs improve some 20%

Chinese Privatization Case

• State-owned enterprises (SOEs) are listed on exchanges, making them eligible for private ownership
• In the early 1990s, China launched the Shanghai and Shenzhen Stock Exchanges
• Approximately 4,400 companies are listed on exchanges in China, in 2021
• “A-shares” are for Chinese citizens, “B-shares” or “H-shares” are for foreigners
• The Chinese government retains majority stakes in most public firms

Trade Liberalization and Economic Integration

• The theory of comparative advantage underpins trade
• Countries benefit if they specialize and trade efficiently
• The theory of relative advantage, not absolute advantage, is relevant
• International trade should increase total welfare of the world's citizens

Trade Liberalization and Economic Integration (1)

• The General Agreement on Tariffs and Trade (GATT) was founded in 1947
• The agreement reduced trade barriers between nations
• The World Trade Organization (WTO) replaced GATT
• WTO has power to enforce trade rules
• China joined in 2001
• The Doha Round WTO talks stalled due to developed/developing countries

Trade Liberalization and Economic Integration (2)

• The European Union (EU) includes 27 nations
• The EU has countries that have eliminated barriers to the free flow of goods
• The North American Free Trade Agreement (NAFTA) phased out trade impediments
• NAFTA included the U.S., Canada and Mexico, between 1994
• In November 2018, a new accord was signed: U.S.-Mexico-Canada-Agreement (USCMA)

Global Financial Crisis of 2008 to 2009

• The subprime mortgage crisis led to a credit crunch and global crisis
• Over-borrowing/risk-taking by households amplified the crisis
• Securitization transmitted the crisis globally
• Securitization allows loan originators to avoid bearing the default risk
• Lending standard are compromised and moral hazard is increased
• “Invisible hands” of free markets may not self-regulate excesses/banking crises.