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:

Exporting/Importing
Licensing Agreements
Joint Ventures/Strategic Alliances.
Portfolio Investment
Foreign Direct Investment 1
(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) The Global Financial System and the Global

Financial Manager. 2
 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. 3
 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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 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:
Kx = KRf + βx ( Km - KRf )

 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 examining ICAPM. 6
 The Arbitrage Pricing Theory
✦ 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 7
✦ 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. 8
 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." 9
 Motivation For Overseas Expansion
Why do Firms Expand Internationally?
Common Explanations Include:

1) 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.
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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.
✦ 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. 11
✦ 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.
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✦ 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, and 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. 13
✦ 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.
✦ Contemporary global economy is moving away
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. 14
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).
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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:
✦ 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
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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
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. 19
 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.
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 Externalization
 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.

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 5) 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. 22
✦ 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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 Oligopoly Model:
✦ Posits that firms expand overseas to exploit their
quasi-monopoly advantages - e.g., access to
capital, possession of differentiated products,
technology, and superior management.
✦ Horizontal investments abroad are made to expand
a firms operation or to reduce the number of
competitors.
✦ Vertical investments abroad are made to raise
barriers to entry for new competitors, and to
protect oligopoly positions.
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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.

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. 26
 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.

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 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.).

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✦ Some of the motives for investors to penetrate
foreign financial markets include:
Motives for International Investments:
- Why investors invest in foreign markets?
- Why creditors provide credit in foreign markets?
Economic conditions, exchange rate expectations,
international diversification, differential interest rates.
Motives for Firms to Obtain Funds from Foreign
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.
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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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 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. 31
✦ 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 royalty charges.
✦ He/she has the ability to circumvent exchange
controls and other regulations, tap previously
inaccessible investment and financing
opportunities, and exploit tax differentials across
markets….and more!
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General Economic News and Information
◆ The Economist

◆ The Financial Times

◆ The Wall Street Journal

◆ The New York Times

◆ News Link

◆ CNN Financial Network

◆ Business Week

◆ The Washington Post

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