Scope and Features of IFM.

(i)

Motivation for Overseas Expansion:

The Process of Overseas Expansion:
Foreign trade Licensing Management Contracting Joint Ventures/Strategic Alliances Acquire existing operations Invests in the majority equity shares
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(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). The Product Cycle Theory Internalization Theory Other Motives - Portfolio Theory, Oligopoly Model, Strategic Motives, Behavioral Motives. A Synthesis of Theories: The Eclectic Theory (OLI). (iii) The Evolution of International Financial Markets. (IV) Global Financial Manager role.
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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 3 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. 4

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.
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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: - Inflation - GDP/GNP Growth - Major Political Developments - Interest Rates - And Much More
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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. 7

 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 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. 8

Motivation for Overseas Expansion

Why do Firms Expand Internationally? Common Explanations Include:

1. Theory of Comparative Advantage

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.
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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.

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2)

Imperfect Market Theory

Countries differ with respect to their resource endowments(financial asset donation made to a nonprofit group). 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).

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

In reality there are costs and often restrictions on the transfer of resources across countries. Firms move to other countries to take advantage of the availability of certain resources.
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 Theory

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.
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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 market. At this stage, defensive foreign manufacturing locations are sought where market imperfections in the cost of factors of production create a chance for lower unit production costs.

Product differentiation is a common strategy to prolong the demand (foreign) for the products.
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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. 15

4) Other Motives for Overseas Expansion

Portfolio Theory: Rests on two essential variables of 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.

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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.

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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. 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.

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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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Forward: is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today. Future: standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date.

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option: is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. Swap : is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.

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Role of international financial manager in MNCs

1.Currency

Transactions 2.Managing foreign exchange risk exposure 3.Global Money Management 4.Financing international Business Operations

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 1.Currency

Transactions:

It takes place when MNCs wants to make foreign investment. Making payments to the clients

Types

of Currency Transactions

Spot Trade Forward Trade

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 Spot

Trade An agreement to trade currencies based on the exchange rate today for settlement immediately(on the spot), technically within two business days
Forward

Trade An agreement to exchange currency at a specified future date at a specified price agreed upon today (also called a forward contract)
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 Foreign

exchange risk : It is the possibility of a gain or loss to a firm that occurs due to unanticipated changes in exchange rate
Types

of foreign exchange risk exposure Translation Exposure Transactions Exposure Economic Exposure
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 Translation

Exposure --Relates to the change in accounting income and balance sheet statements caused due to changes in exchange rates. Transactions Exposure It refers to the extent to which the future value of the firms domestic cash flow is effected by exchange rate fluctuations. Economic Exposure It refers to the degree to which a firm present value of future cash flows can be influenced by exchange rate fluctuations.
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 Global

Money Management: Money management decisions attempt to manage global cash resources efficiently It includes: Minimizing Cash Balances Reducing Transaction Cost

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 Minimizing

Cash Balances Firms need cash balances on hand for notes pay able and unexpected demands To keep cash accessible, cash reserves are usually invested in money market accounts that offer low rates of interest If firms could invest for a longer time frame, they could earn higher rates of interest

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 Reducing

Transaction Costs Transaction costs are the cost of exchange Every time a firm changes cash from one currency to another, they face transaction costs Most banks also charge a transfer fee for moving cash from one location to another Multilateral Netting (An arrangement among multiple parties that
transactions be summed, rather than settled individually. Multilateral netting not only streamlines the settlement process, it also reduces risk by specifying that, in the event of a default or some other termination event, all outstanding contracts are likewise terminated. Generally speaking, multilateral netting is enabled via a membership organization like an

) can reduce the number of transactions between subsidiaries and the number of transaction costs 30
exchange

 Financing

International Business Operations EXIM Bank (Export-Import Bank). Loans from the parent company or a sister affiliate. Eurodollar loans. Eurobond market International Equity markets. The International Finance Corporation (IFC)

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 CONCLUSION The

job of International Finance manager is getting tough, tougher and toughest these days

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