International Finance Lecture Slides Chp. 1

International Finance chp. 1

1. Multinational Business Finance Fifteenth Edition, Global Edition Chapter 1 Multinational Financial Management: Opportunities and Challenges Copyright © 2021 Pearson Education Ltd. All Rights Reserved Slides in this presentation contain hyperlinks. JAWS users should be able to get a list of links by using INSERT+F7

2. Learning Objectives 1.1 Explore the global financial marketplace—players and playing field 1.2 Consider how the theory of comparative advantage applies to multinational business 1.3 Examine how international financial management differs from domestic financial management 1.4 Discover the steps and stages of the globalization process

3. The Multinational Enterprise (M N E) The October–December 2014 quarter was a challenging one with unprecedented currency devaluations. Virtually every currency in the world devalued versus the U.S. dollar, with the Russian Ruble leading the way. While we continue to make steady progress on the strategic transformation of the company—which focuses P&G on about a dozen core categories and 70 to 80 brands, on leading brand growth, on accelerating meaningful product innovation and increasing productivity savings—the considerable business portfolio, product innovation, and productivity progress was not enough to overcome foreign exchange. —P&G News Release, January 27, 2015 A multinational enterprise (M N E) has operating branches, subsidiaries, or affiliates located in foreign countries. Today, digital startups can become multinational enterprises in hours

4. The Global Financial Marketplace Assets, institutions, and linkages comprise one method to map global capital markets (see Exhibit 1.1). Assets are debt securities issued by governments (e.g., U.S. Treasury Bonds). These form the baseline for other forms of financing. Institutions are the central banks, commercial, and investment banks. Their health keeps the global financial system stable. Linkages are the interbank networks using currency. Without ready exchange of currencies the market is hard-pressed to operate efficiently.

5. Exhibit 1.1 Global Capital Markets The global capital market is a collection of institutions (central banks, commercial banks, investment banks, not-forprofit financial institutions like the I M F and World Bank) and securities (bonds, mortgages, derivatives, loans, etc.), which are all linked via a global network-the Interbank Market . This interbank market, in which securities of all kinds are traded, is the critical pipeline system for the movement of capital. For long description, see

6. Appendix 1 The exchange of securities-the movement of capital in the global financial system-must all take place through a vehicle-currency. The exchange of currencies is itself the largest of the financial markets. The interbank market, which must pass-through and exchange securities using currencies, bases all of its pricing through the single most widely quoted interest rate in the world-L I B O R (the London Interbank Offered Rate).

7. The Market for Currencies Most currencies are quoted against the dollar as in “so many units per dollar .” Computer symbols (I S O-4217 codes) are used in digital networks. Some currencies are known by more than one name. Exhibit 1.2 provides selected currency exchange rate quotes.

8. Exhibit 1.2 Selected Global Currency Exchange Rates for January 2, 2018 (1 of 2) For long description, see

9. Appendix 2

10. Exhibit 1.2 Selected Global Currency Exchange Rates for January 2, 2018 (2 of 2) For long description, see

11. Appendix 3 Note that a number of different currencies use the same symbol (for example both China and Japan have traditionally used the ¥ symbol, which means “round” or “circle,” for yen and yuan respectively. All quotes are mid-rates, and are drawn from the Financial Times .

12. Financial Globalization and Risk (1 of 2) Back in the halcyon pre-crisis days of the late 20 th and early 21 st centuries, it was taken as self evident that financial globalization was a good thing. But the subprime crisis and Eurozone dramas are shaking that belief…[W]hat is the bigger risk now—particularly in the Eurozone—is that financial globalization has created a system that is interconnected in some dangerous ways. —“Crisis Fears Fuel Debate on Capital Controls” Financial Times, December 15, 2011

13. Financial Globalization and Risk (2 of 2) Risks must be explored, considered, and managed International monetary system is under constant scrutiny Large fiscal deficits can result in negative interest rates Exchange rates are constantly in flux Ownership and governance vary dramatically across the world, particularly for the privately held or family-owned business Global capital markets have become less open and accessible Increasingly complicating financial management with capital flows

14. Eurocurrencies and Eurocurrency Interest Rates (1 of 2) Eurocurrencies (a major linkage in the global and capital markets) These are domestic currencies of one country on deposit in a second country The Eurocurrency markets serve two valuable purposes: Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity The Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs (including export and import financing)

15. Eurocurrencies and Eurocurrency Interest Rates (2 of 2) The eurocurrency market is relatively free from governmental regulation and interference. Interest rate is referred to as the L I B O R . Oftentimes a low spread exists with deposit and loan rates.

16. The Theory of Comparative Advantage (1 of 7) The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy: free trade; perfect competition; no uncertainty; costless information; and no government interference.

17. The Theory of Comparative Advantage (2 of 7) The theory contains the following features: Exporters in Country A sell goods or services to unrelated importers in Country B Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology Firms in Country B do likewise, given the factors of production found in Country B In this way the total combined output of A and B is maximized

18. The Theory of Comparative Advantage (3 of 7) Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally

19. The Theory of Comparative Advantage (4 of 7) Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons: Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations) At least two factors of production – capital and technology – now flow directly and easily between countries

20. The Theory of Comparative Advantage (5 of 7) Modern factors of production are more numerous than in this simple model Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale

21. The Theory of Comparative Advantage (6 of 7) Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both M N E s and domestic firms. The comparative advantage of the 21st century, however, is one based more on services, and their cross-border facilitation by telecommunications and the Internet. The source of a nation’s comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology.

22. The Theory of Comparative Advantage (7 of 7) Many locations for supply chain outsourcing exist today. It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage. Clearly, the extent of global outsourcing is reaching out to every corner of the globe.

23. What Is Different About International Financial Management? Exhibit 1.3 summarizes the differences. Culture and history differ among countries Corporate governance Greater levels of foreign exchange and political risks Financial theory and applications are modified in the global versus domestic marketplace Specialized and complicated financial instruments become tools of the trade

24. Exhibit 1.3 What Is Different About International Financial Management? Concept International Domestic Culture, history, and institutions Each foreign country is unique and not always understood by M N E management Each country has a known base case Corporate governance Foreign countries’ regulations and institutional practices are all uniquely different Regulations and institutions are well known Foreign exchange risk M N E s face foreign exchange risks due to their subsidiaries, as well as import/export and foreign competitors Foreign exchange risks from import/export and foreign competition (no subsidiaries) Political risk M N E s face political risk because of their foreign subsidiaries and high profile Negligible political risks Modification of domestic finance theories M N E s must modify finance theories like capital budgeting and the cost of capital because of foreign complexities Traditional financial theory applies Modification of domestic financial instruments M N E s utilize modified financial instruments such as options, forwards, swaps, and letters of credit Limited use of financial instruments and derivatives because of few foreign exchange and political risks

25. Market Imperfections: A Rationale for the Existence of the Multinational Firm (1 of 2) M N E s strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for M N E s. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than their local competitors.

26. Market Imperfections: A Rationale for the Existence of the Multinational Firm (2 of 2) Strategic motives drive the decision to invest abroad and become a M N E and can be summarized under the following categories: Market seekers Raw material seekers Production efficiency seekers Knowledge seekers Political safety seekers These categories are not mutually exclusive.

27. The Globalization Process Stage I: early domestic phase growing into the international trade phase (Exhibit 1.4) Stage II: A successful firm will continue to grow from simple international trade to the multinational phase characterized by production and investment both at home and abroad (Exhibit 1.5) The increase in foreign subsidiaries increases currency risks and exposures (Exhibit 1.6) Growth may be limited by the twin agency problems of corporate insiders and the rulers of sovereign states (Exhibit 1.7)

28. Exhibit 1.4 Aidan Corp: Initiation of the Globalization Process For long description, see

29. Appendix 4

30. Exhibit 1.5 Aidan’s Foreign Direct Investment Sequence For long description, see

31. Appendix 5

32. Exhibit 1.6 Selected Consolidated Income Results for Aidan ( Ireland ) As an Ireland-based multinational company, Aidan must consolidate the financial results (in this case, sales and earnings from the income statements) of foreign subsidiaries. This requires converting foreign currency values into euros . For long description, see

33. Appendix 6 Aidan, for the year shown, generated 61.3% of its global sales in Ireland, with those sales making up 58.9% of its consolidated profits. From quarter to quarter and year to year, both the financial performance of the individual subsidiaries will change in addition to exchange rates. * This is a simplified consolidation. Actual consolidation accounting practices require a number of specific line item adjustments not shown here.

34. Exhibit 1.7 The Limits of Financial Globalization There is a growing debate over whether many of the insiders and rulers of organizations with enterprises globally are taking actions consistent with creating firm value or consistent with increasing their own personal stakes and power. For long description, see

35. Appendix 7 If these influential insiders are building personal wealth over that of the firm, it will indeed result in preventing the flow of capital across borders, currencies, and institutions to create a more open and integrated global financial community. Source : Constructed by authors based on “The Limits of Financial Globalization,” Rene M. Stulz, Journal of Applied Corporate Finance , Vol. 19, No. 1, Winter 2007, pp. 8–15.

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37. Appendix 1 Long Description for a diagram of global capital markets linked through the Interbank market. The diagram is of the global capital markets and the London Interbank Market or L I B O R in which all kinds of securities are traded. The Interbank market is in the center with three bank boxes around it. There is an inverse triangle, titled currency, linking the three bank boxes with L I B O R. The bank on the left has three arrows emanating from it, toward boxes named mortgage loan, corporate loan and corporate bond. The bank on the right has three arrows springing toward boxes titled public debt, private debt and private equity. The bank at the bottom has two arrows headed toward boxes titled central banks and institutions. Return to presentation

38. Appendix 2 (1 of 2) Long Description for a table displaying selected global currency exchange rates. The table displays selected global currency exchange rates as of January 2, 2018. There are seven columns titled country, currency, symbol, code, currency equal to one dollar, currency equal to one euro, currency equal to one pound. The data from the table are presented below: A table has 21 rows and 7 columns. The columns have the following headings from left to right. Country, Currency, Symbol, Code, Currency to equal 1 Dollar, Currency to equal 1 Euro, Currency to equal 1 Pound, . The row entries are as follows. Row 1. Country, Argentina. Currency, peso. Symbol, P s. Code, A R S. Currency to equal 1 Dollar, 18.535. Currency to equal 1 Euro, 22.3254. Currency to equal 1 Pound, 25.1697. Row 2. Country, Australia. Currency, dollar. Symbol, A dollar sign. Code, A U D. Currency to equal 1 Dollar, 1.2769. Currency to equal 1 Euro, 1.538. Currency to equal 1 Pound, 1.734. Row 3. Country, Brazil. Currency, real. Symbol, R Dollar sign. Code, B R L. Currency to equal 1 Dollar, 3.2634. Currency to equal 1 Euro, 3.9307. Currency to equal 1 Pound, 4.4315. Row 4. Country, Canada. Currency, dollar. Symbol, C Dollar sign. Code, C A D. Currency to equal 1 Dollar, 1.2505. Currency to equal 1 Euro, 1.5062. Currency to equal 1 Pound, 1.6981. Row 5. Country, Chile. Currency, peso. Symbol, Dollar sign. Code, C L P. Currency to equal 1 Dollar, 607.145. Currency to equal 1 Euro, 731.3062. Currency to equal 1 Pound, 824.4772. Row 6. Country, China. Currency, yuan. Symbol, The yuan symbol is a capital Y with 2 horizontal bars across the Y’s vertical bar.. Code, C N Y. Currency to equal 1 Dollar, 6.4967. Currency to equal 1 Euro, 7.8253. Currency to equal 1 Pound, 8.8222. Row 7. Country, Czech Republic. Currency, koruna. Symbol, K c. Code, C Z K. Currency to equal 1 Dollar, 21.1802. Currency to equal 1 Euro, 25.5115. Currency to equal 1 Pound, 28.7617. Row 8. Country, Denmark. Currency, krone. Symbol, D k r. Code, D K K. Currency to equal 1 Dollar, 6.18. Currency to equal 1 Euro, 7.4439. Currency to equal 1 Pound, 8.3922.