FIN 6605 chapter 01 introduction and overview of issues

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 (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 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 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 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 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 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  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  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” Motivation for Overseas Expansion Why Firms Expand Internationally? Common Explanations Include: 1) Theory of Absolute Advantage 1b) 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 10   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 21 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 riskreturn tradeoff through international diversification 23  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 24  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 25   : 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 Behavioral Considerations 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 27 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.) 28  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 29 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 30 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! 32 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 33 Stay Informed on Global Issues             The PIIGS of the EU The EU 27 and the Eurozone 17 The BRIC Countries The OECD (30 Countries) The G 20 Countries The World Bank The International Monetary Fund (IMF) International Finance Corporation (IFC) Bank for International Settlements (BIS) The United Nations UNCTAD WTO 34           Major Currencies of the World and Exchange Rates Major Stock Market Indexes Major Global/Offshore Financial Centers Major Commodities (oil, gold, ) Major Interest Rates in the US Levels of the Three Major Indexes (Dow, S&P 500, NAS) US Unemployment Rate US Inflation Rate US National Debt (about $13 Trillion, 05/2010) Capitals of Major Countries 35 ... Synthesis of Theories: The Eclectic Theory (OLI) ◆ (iii) The Evolution of International Financial Markets (IV) The Global Financial System and the Global Financial Manager The Scope of International Finance... 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... transfer pricing, and other operational policies  International Financial/Investment Instruments: Survey of instruments, comparison of performances, exploration of optimal combination of securities