FIN 6605 chapter 01 introduction and overview of issues

[Common Theories/Explanations/Hypotheses] ◆ Theory of Comparative Advantage Classical Trade Theory.. The Scope of International Finance Three conceptually distinct but interrelated parts

AJAFIN 6605-01 Introduction and Overview of Issues

Introduction to International Finance:

Scope and Features.

 Motivation for Overseas Expansion:

(i) The Process of Overseas Expansion:

(ii) Why Companies Engage in International Business [Common

Theories/Explanations/Hypotheses]

◆ Theory of Comparative Advantage (Classical Trade Theory).

◆ Imperfect Market Theory (Theory of Factor Endowments).

Strategic Motives, Behavioral Motives

(iii) The Evolution of International Financial Markets.

(IV) The Global Financial System and the Global

Financial Manager.

The Scope of International Finance

Three conceptually distinct but interrelated parts are

identifiable in international finance:

 International Financial Economics: concerned with

causes and effects of financial flows among nations -

application of macroeconomic theory and policy to the global economy.

 International Financial Management: concerned with

how individual economic units, especially MNCs, cope with the complex financial environment of international business Focuses on issues most relevant for making

sound business decision in a global economy.

 International Financial Markets: concerned with

international financial/investment instruments, foreign

exchange markets, international banking, international securities markets, financial derivatives, etc.

Distinguishing Features of International Finance:

Arbitrage:

 Purchase of securities or commodities in one market for immediate resale in another to profit from a price

discrepancy

 Tax Arbitrage: shifting of gains or losses from one tax

jurisdiction to another in order to profit from differences

in tax rates

 Risk Arbitrage: the process which ensures that, in

equilibrium, risk-adjusted returns on different securities are equal, unless market imperfections hinder the

adjustment process.

The process of arbitrage ensures market efficiency.

Market Efficiency

Weak-form Efficient: historical information plus

current 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.

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:

K x = K Rf + βx ( K m - K Rf )

 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

The Arbitrage Pricing Theory (APT)

 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 number of systematic factors rather than a single factor as in the case of CAPM.

 Factors expected to have an impact on all assets:

 Exchange Risk: the risk of loss from unexpected

changes in the exchange rates

 Political Risk: the risk of loss from unforeseen

government action or other political/environmental

events e.g., riots, acts of terrorism, etc

International Finance exploits the fact macroeconomic

fluctuations among nations are less uniform than those among regions of the same country

 National governments still conduct macroeconomic

policies with considerable autonomy - price levels,

interest rates, real income, and employment tend to vary more across countries than within a country

 Hence risk reduction opportunities exist through

international diversification - especially into emerging markets

 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.

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 in scope 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”

Motivation for Overseas Expansion

Why do Firms Expand Internationally?

Common Explanations Include:

1) Theory of Absolute Advantage

1b) Theory of Comparative Advantage

(the classical theory of international trade first developed

by Adam Smith and David Ricardo)

 Theory argues that each country should specialize in the

production and export of those goods it can produce with relative efficiency

 Underlying this theory is the assumption that goods and

services can move internationally but factors (land,

labor, and capital) are relatively immobile

 In addition this theory deals only with trade in

commodities (undifferentiated products), and ignores the roles of transportation costs, economies of scale, and technology in international trade.

 It is a static rather than a dynamic theory.

Nevertheless it is a valuable theory that still provides

well-reasoned theoretical foundation for free trade arguments

 Classical trade theory assumes that countries differ

enough in terms resource endowments and economic skills for those differences to be at the center of

analysis of corporate competitiveness.

 In the world of Adam Smith and David Ricardo, a

company’s nationality is the key determinant of its

international success.

 Classical trade theory, however, is becoming

increasingly irrelevant in today’s global business environment where differences among

corporations are becoming more important than aggregate differences among countries.

 Today, the increasing capacity of even small

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

 Major developed economies are now more

homogeneous than before in terms of living

standards, life styles, and economic institutions and their factors of production move rapidly

across borders in search of higher returns.

 Natural 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 .

 Technological know-how has become a global pool with U.S MNCs outsourcing software development, call

centers, accounting, engineering, manufacturing, and other services to India, China, Mexico, Brazil …….

 As a result of rapid development in the technology of

communication, duplication, reproduction, and storage of information, companies can now trade education, skills, and other factors internationally

 Therefore, contrary to the classical theory, the very existence of many multinational enterprises is based

on the international mobility of certain factors of

production (capital, technology, entrepreneurship…)

 Information technology makes it possible for worker skills to flow with little regard to borders .

from a system in which products are made in one country and exported to others to one in which

value is added in several different countries

depending on advantages in labor costs and unique national attributes or skills.

2) Imperfect Market Theory

 Countries differ with respect to their resource

endowments

 Resources are somewhat immobile and firms must

sometimes seek out these resources

In a world of perfect markets, the following

conditions will hold:

– Zero information cost = free flow of information

across countries

– Zero cost of labor mobility.

– Zero transportation costs.

– Zero cost of transferring funds.

– One global currency (no currency risk).

 If all these assumptions hold, there will be a reduced incentive to establish certain types of subsidiaries

 However it is also true today that the existence of

MNC rests on international mobility of certain

factors of production - capital, technology, etc.

3) The Product Cycle

 Suggests that direct foreign investment is a natural

stage in the life cycle of a new product from its

inception to its maturity and possible eventual

decline.

 New, technologically advanced, or differentiated,

products are discovered/launched typically in an

advanced industrial country (e.g U.S., UK, or Japan)

New products, e.g., high definition televisions, are

first introduced in a "home market."

 Close coordination of production and sales are

required while product is improved, and production process standardized

 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 home

Two fundamental tenets of the product life cycle hypothesis are technology and the market.

 Technology: as a critical component of both product

development and production

 The Market: size and structure of the international

market are increasingly becoming critical factors in the determination of trade and investment patterns

 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.

4) Internalization

 Is the extension of ownership by a firm to cover new

markets, new sources of material, and new stages of the production process

 It covers horizontal and vertical integration, purchase

of labor (specialized labor), capital and technology Firm also internalizes R&D

 The concept of appropriability implies that organizations

which possess a unique body of know-how will attempt

to avoid dissipation of this know-how to third parties

 Proprietary firm-specific advantages yield economic

rents when exploited on a world-wide basis.

 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 involve the sale

of the technology rather than the sale of the products

of the technology.

5) Other Motives for Overseas Expansion

risk and return Risk is a measure of the variability of returns

associated with an investment.

 Investors are generally risk averse Portfolio theory shows that in many situations the risk

of individual projects tend to offset one another

 The key element in portfolio theory is the correlation coefficient between securities in the portfolio.

 When securities with low degrees of correlation

are combined in a portfolio, the risk of the

portfolio is less than the sum of the risks of the

individual components.

 Since domestic and foreign economic cycles are not perfectly synchronized, their securities tend to be less correlated with one another compared to

purely domestic securities.

 International investment may therefore be

motivated by the opportunities for superior

risk-return tradeoff through international

diversification.

 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

Behavioral Considerations: Foreign expansion may be

motivated by behavioral considerations

 A dominant individual or individuals may have

personal preferences for a particular foreign location ego, commitment, dream, "ancestral pull," to give something back, family commitment, etc.

6) A Synthesis

 Motives for overseas expansion are too closely

interrelated to be considered separately - they are not mutually exclusive.

 The Eclectic Model attempts to synthesize some of

the theories.

 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 a host country while "specific-ownership" advantages favor the investing firm.

 A combination of advantages for both company and host country is necessary for international expansion.

Evolution of International Financial Markets

 In recent years, financial markets have become integrated in many respects.

 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.).

 Some of the motives for investors to penetrate foreign financial markets include:

- Why investors invest in foreign markets?

- Why creditors provide credit in foreign markets?

Economic conditions, exchange rate expectations,

international diversification, differential interest rates

Markets: 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

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

The Global Financial System and the Global

Financial Manager

 In a world of global markets rather than national or local markets, the global financial manager wears many hats

 He/she combines the knowledge of product or service; sources of "raw" materials and other

resources; alternatives to these inputs; diversified funding sources; changing relative values of the various factors and political and economic choices and innovations in key nations.

 He/she is a global scanner, and a global thinker The global financial manager is able to shift

resources/factors/profits among affiliates through

transfer pricing on goods and services traded

internally, dividend payments, inter-company loans, leading/lagging inter-company payments, fees and

General Economic News and Information

◆ The Economist

◆ The Financial Times

◆ The Wall Street Journal

◆ The New York Times

Stay Informed on Global Issues

 The PIIGS of the EU

 The EU 27 and the Eurozone 17

 The BRIC Countries

 The OECD (30 Countries)

 The G 20 Countries

 The World Bank

 The International Monetary Fund (IMF)

 International Finance Corporation (IFC)

 Bank for International Settlements (BIS)

 The United Nations