Topic 1 :: Introduction

Dr. Md Mohan Uddin

Introduction to International Finance

Finance in an international context

Why do we need to study international finance?
We are living in a highly globalized and integrated
world economy
Continued liberalization of international trade
further internationalizes the consumption pattern
Globalized production: MNCs source inputs and locate
productions anywhere in the world
Integrated financial markets: internationally diversified
investment, internationally tradable financial securities

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What makes international finance
special?
Three major dimensions make international finance different from purely
domestic finance:
Foreign exchange and political risks
Market imperfections
Expanded opportunity sets

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What makes international finance special?
Foreign exchange and political risks

Unexpected fluctuations of the exchange rates may adversely affect the MNCs
as well as individuals who are engaged in cross border transactions
Exchange rate uncertainty may affect all the major economic functions
including consumption, production, and investment.
Sovereign country can change the rules, e.g.,
Tax rules
Expropriation of assets
In some countries, there is a lack of tradition of the rule of law.

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What makes international finance special?
Market imperfections

Market imperfections represent various frictions and impediments preventing

markets from functioning perfectly.
Such frictions/ impediments/ barriers include
Legal restrictions
Excessive transportation and transaction costs
Information asymmetry
Discriminatory taxation

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What makes international finance special?
Market imperfections

Often, MNCs are motivated to locate production overseas due to such market
imperfections
Imperfection in the international financial market often restrict the extent to
which investors can diversify their portfolios.

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What makes international finance special?
Expanded opportunity set

If firms venture into the arena of global markets, they can benefit from an
expanded opportunity set by:
locating production in any country/region of the world to maximize performance
raising fund in any capital market where the cost capital is the lowest.
deploying assets on a global basis to gain from greater economies of scale.

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What makes international finance
special?
International finance is different from domestic finance and to be benefitted
from it,
maximize the benefits from the global opportunity set
control exchange rate and political risks
manage various market imperfections

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Effective international financial
management
Effective financial management requires an underlying goal.
Shareholder wealth maximization is considered as the fundamental goal of
sound financial management.
Shareholder wealth maximization is long accepted as a goal in the Anglo-
Saxon countries like Australia, Canada, UK, and USA.

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Effective international financial
management
In other countries like France or Germany, shareholders are viewed as merely
one among many stakeholders of the firm including:
Employees
Suppliers
Customers
In Japan, managers have typically sought to maximize the value of the
keiretsua family of firms to which the individual firms belongs.

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Effective international financial
management
As a result of recent liberalization and international integration of capital
markets even the managers in France, Germany, Japan, and other non-Anglo-
Saxon countries are beginning to pay serious attention to shareholder wealth
maximization.
Shareholder wealth maximization does not imply that the firm would not
pursue other goals.
Rather, shareholder wealth maximization also helps accomplishing other
legitimate goals.

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Effective international financial
management
As shown by a series of recent corporate scandals at companies like Enron,
WorldCom, and Global Crossing, managers may pursue their own private
interests at the expense of shareholders when they are not closely monitored.
These calamities have painfully reinforced the importance of corporate
governance, i.e., the financial and legal framework for regulating the
relationship between a firms management and its shareholders.

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Effective international financial
management
These types of issues can be much more serious in many other parts of the
world, especially emerging and transitional economies, such as Indonesia,
Korea, and Russia, where legal protection of shareholders is weak or virtually
non-existing.

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Globalization of the World Economy:
Major Trends and Developments
Key trends and developments include:
Emergence of Globalized Financial Markets
Emergence of the Euro as a Global Currency
Europes Sovereign Debt Crisis of 2010
Trade Liberalization and Economic Integration
Privatization
Global Financial Crisis of 2008-2009

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Globalization of the World Economy:
Emergence of globalized financial markets

Deregulation of Financial Markets

Advances in Technology
have greatly reduced information and transaction costs, which has led to:
Financial Innovations, such as
Currency futures and options
Multi-currency bonds
Cross-border stock listings
International mutual funds

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Globalization of the World Economy:
Emergence of the euro as a global currency

The advent of the euro in 1999 represents a momentous event in the history
of world financial system
More than 300 million Europeans are using the common
currency
Many new members of the EU would like to adopt the euro
The transaction domain of the euro may become larger
than the USD in near future

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Globalization of the World Economy:
Europes sovereign-debt crisis of 2010
All EU member states are automatically members of both the Economic and
Monetary Union (EMU) and the Stability and Growth Pact (SGP)
SGP is an agreement, among the member states of the European Union, to
facilitate and maintain the stability of the EMU
The SGP requires each Member State to implement a fiscal policy aiming for
the country to stay within the limits on government deficit (3% of GDP)

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Globalization of the World Economy:
Europes sovereign-debt crisis of 2010
In December 2009, the new Greek government revealed that the actual
budget deficit was 12.7 percent compared to the previously forecasted 3.7
percent based on falsified national account data
Therefore, Greece actually was in a serious violation of the SGP.
This situation was a result of excessive borrowing and spending, with wages
and prices rising faster than productivity

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Globalization of the World Economy:
Europes sovereign-debt crisis of 2010
Greece could not use the traditional means of depreciating national currency
as the country had adopted the euro.
Investors became worried about sovereign default
They started to sell off Greek government bonds
The panic spread to other weak European countries, especially Ireland,
Portugal, and Spain

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Globalization of the World Economy:
Europes sovereign-debt crisis of 2010
In 2010, credit rating agencies downgraded the government bonds of the
affected countries
Borrowing and refinancing became more costly
Although the debt crisis in Greece accounted for only about 2.5% of Eurozone
GDP, it quickly escalated to a Europe-wide debt crisis

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Globalization of the World Economy:
Europes sovereign-debt crisis of 2010

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Globalization of the World Economy:
Europes sovereign-debt crisis of 2010
On May 9, 2010, EU countries led by France and Germany, jointly with IMF, put
together a massive Euro 750 billion package to bail out Greece and other
weak countries.
The agreement on the bailout plan was slow and thus became expensive due
to
Europes lack of political union
Fragmented decision making structure

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Globalization of the World Economy:
Trade liberalization and economic integration
Over the past 50 years, international trade increased about twice as fast as
world GDP.
There has been a change in the attitudes of many of the worlds governments,
who have abandoned mercantilist views and embraced free trade as the
surest route to prosperity for their citizenry.

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Globalization of the World Economy:
Trade liberalization and economic integration
The General Agreement on Tariffs and Trade (GATT) is a multilateral
agreement among member countries that has reduced many barriers to trade.
The World Trade Organization (WTO) has the power to enforce the rules of
international trade.

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Globalization of the World Economy:
Trade liberalization and economic integration
The European Union (EU) was established to foster economic integration
among the countries of Western Europe.
The North American Free Trade Agreement (NAFTA) calls for phasing out
impediments to trade between Canada, Mexico, and the United States over a
15-year period beginning in 1994.

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Globalization of the World Economy:
Privatization
The selling of state-run enterprises to investors is also known as
denationalization.
Privatization is often seen as socialist economies in transition to market
economies.
By most estimates, this increases the efficiency of the enterprise.
It also often spurs a tremendous increase in cross-border investment.

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Globalization of the World Economy:
Global financial crisis of 20082009
The Great Recession was the most serious, synchronized economic
downturn since the Great Depression of the 1930s.
Factors included:
Households and financial institutions borrowed too much and took too much risk.
This risk was repackaged with securitization.

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Multinational Corporations

A multinational corporation (MNC) is a

firm that has been incorporated in one
country and has production and sales
operations in other countries.
There are about 60,000 MNCs in the
world.
Many MNCs obtain raw materials from
one nation, financial capital from
another, produce goods with labor and
capital equipment in a third country,
and sell their output in various other
national markets.

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