International Financial

Management
 Introduction
• The main objective of international financial
management is to maximise shareholder
wealth.
• Adam Smith wrote in his famous title,
“Wealth of Nations” that if a foreign
country can supply us with a commodity
Cheaper than we ourselves can make it,
better buy it of them with some part of the
produce of our own in which we have some
advantage.
 Basic Functions
• Acquisition of funds (financing decision)
– This function involves generating funds from internal as
well as external sources.
– The effort is to get funds at the lowest cost possible.
• Investment decision
– It is concerned with deployment of the acquired funds in a
manner so as to maximize shareholder wealth.
– Other decisions relate to dividend payment, working
capital and capital structure etc.
– In addition, risk management involves both financing and
investment decision.
 Nature & Scope
• Finance function of a multinational firm has two
functions namely, treasury and control.
– The treasurer is responsible for
• financial planning analysis
• fund acquisition
• investment financing
• cash management
• investment decision and
• risk management
– Controller deals with the functions related to
• external reporting
• tax planning and management
• management information system
• financial and management accounting
• budget planning and control, and
• accounts receivables etc.
 NATURE & SCOPE OF INTERNATIONAL
FINANCE
• International Flow of Funds
• Foreign Exchange Market
• Exchange Rate Determination
• Exchange Rate Risk and its Management (Futures,
Options, Swaps, FRA etc)
• Financing MNCs
• Working Capital Decisions of MNCs
• MNC’s Investment Decisions (or Multinational Capital
Budgeting)
• International Accounting and Taxation
DOMESTIC Vs INTERNATIONAL FINANCIAL
MANAGEMENT
These are also referred to as risks or challenges
of international financial management.
– Foreign Currency Exposure
– Macro Business Environment
– Different Legal and Tax Environment
– Different Group of Stakeholders
– Different Standards of Reporting
– Wide Accessibility of Capital
 Environment at International Level
International financial management practitioners are
required the knowledge in the following fields.
• the knowledge of latest • investment behaviour of
changes in forex rates investors
• instability in capital • export and import trends
market
• Competition
• interest rate fluctuations
• banking sector
• macro level charges
performance
• micro level economic
• inflationary trends
indicators
• demand and supply
• savings rate
conditions etc.
• consumption pattern
 International financial manager will
involve the study of
• exchange rate and currency markets
• theory and practice of estimating future exchange rate
• various risks such as political/country risk, exchange rate
risk and interest rate risk
• various risk management techniques
• cost of capital and capital budgeting in international
context
• working capital management
• balance of payment, and
• international financial institutions etc.
Features of International Finance
• Foreign exchange risk
• Political risk
• Expanded opportunity sets
• Market imperfections
 Foreign exchange risk
• In a domestic economy this risk is generally ignored because a
single national currency serves as the main medium of
exchange within a country.
• When different national currencies are exchanged for each
other, there is a definite risk of volatility in foreign exchange
rates.
• The present International Monetary System set up is
characterised by a mix of floating and managed exchange rate
policies adopted by each nation keeping in view its interests.
• In fact, this variability of exchange rates is widely regarded as
the most serious international financial problem facing
corporate managers and policy makers.
 Political risk
• Political risk ranges from the risk of loss (or gain) from
unforeseen government actions or other events of a
political character such as acts of terrorism to outright
expropriation of assets held by foreigners.
• For example, in 1992, Enron Development Corporation, a
subsidiary of a Houston based Energy Company, signed a
contract to build India’s longest power plant. Unfortunately,
the project got cancelled in 1995 by the politicians in
Maharashtra who argued that India did not require the
power plant. The company had spent nearly $ 300 million
on the project.
 Expanded Opportunity Sets
• When firms go global, they also tend to
benefit from expanded opportunities which
are available now.
• They can raise funds in capital markets where
cost of capital is the lowest.
• The firms can also gain from greater
economies of scale when they operate on a
global basis.
 Market Imperfections
• domestic finance is that world markets today
are highly imperfect
• differences among nations’ laws, tax systems,
business practices and general cultural
environments
 International Trade Theories

• Theory of Mercantilism
• Theory of Absolute Cost Advantage
• Theory of Comparative Cost Advantage
 Theory of Mercantilism
• This theory is during the sixteenth to the three-fourths
of the eighteenth centuries.
• It beliefs in nationalism and the welfare of the nation
alone, planning and regulation of economic activities
for achieving the national goals, restriction imports
and promoting exports.
• It believed that the power of a nation lied in its
wealth, which grew by acquiring gold from abroad.

Cont …
 Theory of Mercantilism
• Mercantilists failed to realize that simultaneous export
promotion and import regulation are not possible in all
countries, and the mere control of gold does not enhance the
welfare of a people.
• Keeping the resources in the form of gold reduces the
production of goods and services and, thereby, lowers welfare.
• It was rejected by Adam Smith and Ricardo by stressing the
importance of individuals, and pointing out that their welfare
was the welfare of the nation.
 Theory of Absolute Cost Advantage
• This theory was propounded by Adam Smith (1776),
arguing that the countries gain from trading, if they
specialise according to their production advantages.
• The pre-trade exchange ratio in Country I would be
2A=1B and in Country II 1A=2B.

Cont …
 Theory of Absolute Cost Advantage
• If it is nearer to Country I domestic exchange ratio
then trade would be more beneficial to Country II
and vice versa.
• Assuming the international exchange ratio is
established IA=IB.
• The terms of trade between the trading partners
would depend upon their economic strength and the
bargaining power.
 Theory of Comparative Cost Advantage
• Ricardo (1817), though adhering to the absolute cost
advantage principle of Adam Smith, pointed out that
cost advantage to both the trade partners was not a
necessary condition for trade to occur.
• According to Ricardo, so long as the other country is
not equally less productive in all lines of production,
measurable in terms of opportunity cost of each
commodity in the two countries, it will still be
mutually gainful for them if they enter into trade.

Cont …
 Theory of Comparative Cost Advantage

– In the example given, the opportunity cost of one

unit of A in country I is 0.89 (80/90) unit of good B
and in country II it is 1.2 (120/100) unit of good B.
– On the other hand, the opportunity cost of one
unit of good B in country I is 1.125 (90/80)units of
good A and 0.83 (100/120) unit of good A, in
country II.
Cont …
 Theory of Comparative Cost Advantage
• The opportunity cost of the two goods are different in both
the countries and as long as this is the case, they will have
comparative advantage in the production of either, good A or
good B, and will gain from trade regardless of the fact that
one of the trade partners may be possessing absolute cost
advantage in both lines of production.
• Thus, country I has comparative advantage in good A as the
opportunity cost of its production is lower in this country as
compared to its opportunity cost in country II which has
comparative advantage in the production of good B on the
same reasoning.
International Business Methods
• Licensing
• Franchising
• Subsidiaries and Acquisitions
• Strategic Alliances
• Exporting
• Management contracting
• Establishing Joint ventures
 Major Trends

 Emergence of Globalized Financial Markets

 Emergence of Euro as a Global Currency
 Trade Liberalization & Economic Integration
 Privatization
Recent Changes in Global Financial Market

Banking System

Opening up of Domestic Financial Market for

foreign borrowers
Individual Portfolios Diversification

Securitization & Disintermediation - Loans, Underwriting

commission, fees

Exchange rate floating vs fixed