INTERNATIONAL FINANCIAL MANAGEMENT

1.1 Why Study International Finance

In today's world finance cannot be anything but international

Enormous growth in the volume of international trade Cross border capital flows and, in particular, direct investment have also grown enormously

1.1 Why Study International Finance (contd.)

Veritable revolution has been taking place in the money and capital markets around the world
Liberalization, integration and innovation have created a giant international financial market which is extremely dynamic and complex

1.1 Why Study International Finance (contd.)

Multilateral negotiations regarding phased removal of trade barriers have made considerable progress and WTO had emerged as a meaningful platform

Post war, World trade has grown faster than World GDP Almost all countries getting integrated with the global economy

1.1 Why Study International Finance (contd.)

Indian economy needs substantial amounts of foreign capital to augment domestic savings Technology up-gradation in India will require continuing import of foreign technology, hardware and software Indias increasing recourse to commercial borrowings and direct and portfolio investments by nonresidents

1.1 Why Study International Finance (contd.)

The efforts of Indian companies to diversify into exports of engineering equipment and turnkey projects will have to be supported by the ability to offer long term financing to buyers A number of companies particularly in the Indian IT sector have begun venturing abroad for strategic reasons either as partners in joint ventures or by establishing foreign subsidiaries

1.1 Why Study International Finance (contd.)

India's growing dependence on international financial markets
Debt Equity FII investment

Indian companies have also been venturing abroad for setting up joint ventures and wholly owned subsidiaries

1.1 Why Study International Finance (contd.)

For those who are willing to master its complexities the global financial market provides endless opportunities for creative financial management; for the unwary, it is a minefield Finance managers must come to grips with the conceptual foundations and practical issues of instruments and markets

INTRODUCTION CASE STUDY

Jim Logan completed UG degree in finance. Dream of owning sports business. Worked in a sporting goods shop while studying and observed that customers want to buy low priced foot ball. But the shop sold only top line foot balls. Hence decided to penetrate the US market with low priced foot ball.

Also knew how to produce foot ball. Goal was to make low priced foot balls and sell them on a whole sale basis. But many sporting goods stores started selling low-priced footballs just before Jim was about to start. Jim did not believe that he would compete with these in the US market and hence planned to go global.

He enquired with his foreign friends about the possibility of getting customers in the foreign markets. But explored the possibility of getting good demand from the foreign market. Jim decided to start a business of producing low priced foot balls and exporting them to sporting goods distributors in foreign countries.

Jim planned to expand his product line over time once he identified other sports products. He decided to call his business Sports Exports Company to avoid any rent and labor expenses. Jim planned to produce the foot balls in his garage and to perform the work himself.

Thus his main expenses were the cost of the material used to produce and expenses associated with finding distributors in foreign countries. Q:1 Is Sports Exports Company a multinational corporation? 2.Why are the agency costs lower for sports Exports Company than for most MNCs?

3.Does Sports Exports Company have any comparative advantage over potential competitors' in foreign countries that could produce and sell footballs there? 4. How would Jim Logan decide which foreign markets he would attempt to enter? Should he initially focus on one or many foreign markets?

5. The Sports Exports Company has no immediate plans to conduct direct foreign investment. it might consider other less costly methods of establishing its business in foreign markets. What methods might the sports Exports Company use to increase its presence in foreign markets by working with one or more foreign companies?

solution

1.Definition of MNC: The firms which are engaged in some form of international business is known as multinational corporation. 2. Agency cost definition: Conflict between managements goal and objective of the firm leads to agency cost.

3. Theories of International Business: Theory of comparative advantage specialization in one product may result in no production of other products so that trade between countries is essential. Theory of Imperfect Market: Factors of production are immobile. Restriction on free transfer of funds and other resources.

Product Life Cycle Theory: Stage1 : Firms create products to accommodate local demand. Stage 2. Firms exports product to accommodate foreign demand. Stage 3. Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

Stage 4 a.- Firm differentiates product from competitors and / or expands product line in foreign country. 4b. Firms foreign business declines as its competitive advantages are eliminated.

Q5

Methods of International Business: International Trade. Licensing Franchising Joint ventures Acquisitions of existing operations Establishing a new foreign subsidiaries.

The process of Expansion

LICENSING EXPORTING SALES SUB SERVICE
FACILTIY DISTRIBUTION SYSTEM-

PRODUCITON OVERSEAS.

The Finance Function

The finance function in a firm can be conveniently divided into two subfunctions viz. accounting and control and treasury management Decisions taken by the treasurer have implications for the controller and vice versa

The Finance Function (contd.)

Treasury Function: Acquisition and allocation of financial resources so as to minimize the cost and maximize the return, consistent with the level of financial risk acceptable to the firm is the core of treasury management Accounting and Control: Internal and External Reporting, MIS, Control, etc.

The Emerging Challenges

Five key categories of emerging challenges can be identified To keep up-to-date with significant environmental changes and analyze their implications for the firm To understand and analyze the complex interrelationships between relevant environmental variables and corporate responses - own and competitive - to the changes in them

The Emerging Challenges (contd.)

To be able to adapt the finance function to significant changes in the firm's own strategic posture To take in stride past failures and mistakes to minimize their adverse impact
To design and implement effective solutions to take advantage of the opportunities offered by the markets and advances in financial theory

Recent Changes in Global Financial Markets

The outstanding feature of the changes during the eighties was integration Both the potential borrower and the potential investor have a wide range of choice of markets there has been a strong trend towards functional unification across the various types of financial institutions within individual markets

Recent Changes in Global Financial Markets (contd.)

The driving forces behind this spatial and functional integration were first, liberalization of cross border financial transactions and, second, deregulation within the financial systems of the major industrial nations

Assets denominated in currencies became more substitutable

various nearly

Recent Changes in Global Financial Markets (contd.)

Deregulation involved action on two fronts

Eliminating the segmentation of the markets for financial services permitting foreign financial institutions to enter the national markets and compete on an equal footing with the domestic institutions

This is a part of the overall trend towards securitization and

disintermediation

Recent changes in Global Financial Markets (contd.)

The attainment of the Economic and Monetary Union (EMU) and the birth of Euro in the closing years of the decade of 1990's There is a race on to come up with increasingly complex and often esoteric products which, it is sometimes said, the bankers themselves do not fully understand

Recent Changes in Global Financial Markets (contd.)

The explosive pace of deregulation and innovation has given rise to serious concerns about the viability and stability of the system Disturbances following a local financial crisis tend to spread throughout the global system at the "speed of thought" making the policy makers' task extremely difficult

Advent of Euro
ref: PK jain & peryard

International Capital market known as Euro market. Euro market is the market where Euro currencies, Bonds, shares and bills are traded. Euro currency is the currency where deposits are made out side the territory of the origin of that currency.

Euro Bank is the bank where Euro currencies are deposited. Euro credit market: participants- Euro Banks , American, Japanese, British, Swiss, French, German, and Asian (Singapore) Chemical banks, JPMorgan, Citicorp, Banker Trust, Chase Manhattan Bank Etc.

Characteristics of Euro Credit: A major part of the (80%) Euro debts are Made in the US$, followed by Pound Sterling, German mark , Japanese Yen, and Swiss Franc. Maturity period are about five years-20 years in some case. Reimbursement in one go (bullet) or in installments.

Interest rate is calculated with respect to a rate of reference increased by a margin. Fixed with reference to LIBOR LIBOR is the rate of money market applicable to short term credits among the banks of London.

Euro Bond Market: Euro Bonds are the bonds issued in Euro Currencies and placed simultaneously and in similar conditions in several countries through an international bank syndicate or consortium . Bonds represent a loan of 5 to 15 years

Difference between Euro credit and Euro Bond.

Cost of Borrowing:EC carry variable rate- EB carry both fixed and Floating rate. Maturity: EC depends on the time EB has longer maturity. Size of the Issue: EC lower than EB. Flexibility: EC with a multicurrency clause can switch over to any currency. EB switch over is costly.

Speed: Funds can be raised quickly often a period of two to three weeks should suffice. EB takes more time .

International Monetary System Introduction

The International Monetary System facilitates transfer of funds between parties, conversion of national currencies into one another, acquisition and liquidation of financial assets, and international credit creation An important constituent of the global financial system

Introduction (contd.)
The relevant aspects of the system Exchange rate regimes, current and past

International liquidity The International Monetary Fund The adjustment process i.e. how does the system facilitate the process of coping with payments imbalances between trading nations Currency blocks and unions such as the EMU

Exchange Rate Regimes

Exchange Rate Regimes
The IMF classifies member countries into eight categories
Currency Union (No separate legal tender) Currency Board Arrangement Conventional Fixed Peg Arrangements Pegged Exchange Rates within Horizontal Bands Crawling Peg Crawling bands Managed float Independent float

The

Exchange Rate Regimes: A Historical Perspective

Gold Standard Gold Specie Standard; Gold Bullion Standard

Gold Exchange Standard

Mint Parity: The exchange rate between any pair of currencies will be determined by their respective exchange rates against gold The gold standard regime imposes very rigid discipline on the policy makers : The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve. When a country loses gold, money supply must contract. Domestic economy governed by external sector.

Exchange Rate Regimes: History

The Bretton Woods System

The exchange rate regime that was put in place after WWII can be characterized as Gold Exchange Standard
The US government undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce Other member countries of the IMF agreed to fix the parities of their currencies with the dollar with variation within 1% on either side of the central parity being permissible

It was an Adjustable Peg system. Central parity could be changed in the face of fundamental disequilibrium.

Exchange Rate Regimes: History

In return for undertaking this obligation, the member countries were entitled to borrow from the IMF to carry out their intervention in the currency markets Whenever the exchange rate tended to move out of the 1% band, the central bank had to sell or buy the foreign currency to bring it back within the band. Devaluation/up valuation when disequilibrium persisted Fundamental Disequilibrium

Exchange Rate Regimes: History

Intervention operations affect the domestic money supply and then the price level, GNP etc. These effects may have an automatic corrective effect Central bank sells forex, money supply contracts, price level reduces, GNP reduces, imports decline, the pressure on home currency reduces. Central bank can sterilize these effects.

Exchange Rate Regimes: History

This system could work as long as other countries had confidence in the stability of the US dollar and in the ability of the US treasury to convert dollars into gold on demand at the specified conversion rate The system came under pressure and ultimately broke down when this confidence was shaken due to various political and some economic factors starting in mid 1960s. Abandoned in 1973 after some attempts to fix it and revive it. Major currencies started floating in early 1973.

Exchange Rate Regimes

Is there an ideal regime? Fixed rates provide a policy anchor & discipline. Freely floating rates provide monetary policy freedom. Economists are reconsidering the merits of a floating exchange rate and monetary policy independence which it apparently bestows on a country. Hard pegs have their problems. It appears therefore that there is no such thing as "the ideal" exchange rate regime for all countries or even for a given country at all times Crawling pegs, crawling bands, managed float etc. are attempts to get the best of both the worlds

Exchange Rate Regimes

One school of thought feels there will be only two types of exchange rate regimes
Truly

fixed rate arrangements Truly market determined, floating rates

The impossible trinity : A country can achieve any two of the following three policy goals but not all three
A

stable exchange rate Monetary policy independence Financial market integration with rest of the world

The role of IMF

The International Monetary Fund (IMF)

Framework of the Articles of Agreement adopted at Bretton Woods in1944 Increasing international monetary cooperation Promoting the growth of trade Promoting exchange rate stability Establishing a system of multilateral payments, eliminating exchange restrictions which hamper the growth of world trade and encouraging progress towards convertibility of member currencies Building a reserve base

The role of IMF

The International Monetary Fund (IMF)

Framework of the Articles of Agreement adopted at Bretton Woods in1944 Increasing international monetary cooperation Promoting the growth of trade Promoting exchange rate stability Establishing a system of multilateral payments, eliminating exchange restrictions which hamper the growth of world trade and encouraging progress towards convertibility of member currencies Building a reserve base

The role of IMF

The International Monetary Fund (IMF)

Framework of the Articles of Agreement adopted at Bretton Woods in1944 Increasing international monetary cooperation Promoting the growth of trade Promoting exchange rate stability Establishing a system of multilateral payments, eliminating exchange restrictions which hamper the growth of world trade and encouraging progress towards convertibility of member currencies Building a reserve base

The International Monetary Fund

Special Drawing Rights (SDRs)
SDR is international fiat money created by IMF and allocated to member countries. Can be used by Central banks to settle payments among themselves. Selected other institutions allowed to hold and use SDRs In order to make SDRs an attractive asset to hold, the Fund pays interest on holdings in excess of a member's cumulative allocation and it charges interest on any shortfalls Have not become popular as reserve asset

The International Monetary Fund

The Role of IMF in the Post-Bretton Woods World

Under the Bretton Woods system the IMF was responsible for the functioning of the adjustable peg system Under the current "non-system" that role has considerably diminished if not eliminated The Fund is mandated to "exercise firm surveillance over the exchange rate policies of members" The Fund has played an important role in tackling the debt crisis of developing countries

The Economic and Monetary Union (EMU): History

Adjustable peg system called Snake was born among the countries belonging to the European Economic Community (EEC) in 1972 In 1979, the snake became the European Monetary System (EMS) The feature that distinguished EMS from the snake was the European Currency Unit (ECU), a SDR-like basket of currencies The ECU was the precursor of the common currency Euro

EMU: History

Monetary Union had been envisaged as a part of the move towards creating a single economic zone in Europe Just when it appeared that Europe will steadily march towards an economic and monetary union as envisaged in the "Maastricht treaty", the system received severe jolts "Growth and Stability Pact" in 1996 The single currency "Euro" came into existence on January 1 1999

The Economic and Monetary Union

After 2002, their individual currencies will cease to exist The parities of the eleven member currencies against each other and against the Euro were irrevocably fixed when Euro was born. At the start 1 Euro = 1 ECU The EMU and the Euro provide a model for other currency unions

How? BOP is kept on a double entry system of book keeping. E.g. if exports are made, there will be a credit for outflow of goods on current account and a corresponding entry of debit for claim on foreigners.