International Finance Meaning, Nature, Principles, Importance

Table of Contents:-

  1. Meaning of International Finance
  2. Nature of International Finance
  3. Principles of International Finance
  4. Importance of Managing International Finance

Meaning of International Finance

International finance is the branch of economies that studies the dynamics of exchange rates, and foreign investment, and how these affect international trade. It also studies international projects, international investments capital flows, and trade deficits. It includes the study of futures, options and currency swaps Together with international trade theory, international finance is also a branch of international economics.

International finance is the examination of institutions, practices, and analysis of cash flows that move from one country to another. There are several significant differences between international finance and its purely domestic counterpart, but the most important is exchange rate risk. Exchange rate risk refers to the uncertainty injected into any international financial decision that results from changes in the price of one country’s currency per unit of another country’s currency. Other differences include new risks resulting from changes in the political environment, the environment for direct foreign investment, and differential taxation of assets and income.

Nature of International Finance

International finance is a distinct field of study and certain features set it apart from others. The important differentiating features of international finance are explained as follows:

  1. Foreign Exchange Risk
  2. Expanded Opportunity Sets
  3. Political Risk
  4. Market Imperfections

Nature of International Finance1) Foreign Exchange Risk

An understanding of foreign exchange risk is essential for managers and investors in today’s dynamic environment, characterized by unpredictable fluctuations in foreign exchange rates. In a domestic economy, this risk is generally disregarded due to a single national currency that serves as a country’s primary medium of exchange. When different national currencies are exchanged for each other, there is a clear risk of volatility in foreign exchange rates. The present International Monetary System is characterized by a combination of floating and managed exchange rate policies, which are adopted by each nation based on their respective interests. This variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policymakers.

2) Political Risk

One of the potential challenges that firms may face in the realm of international finance is political risk. Political risk includes a wide range of potential losses or gains resulting from unforeseen government actions or other politically driven events, including acts of terrorism, as well as the outright expropriation of assets held by foreign entities. Multinational companies (MNCs) must diligently evaluate the political risks in countries where they are currently doing business and where they expect to establish subsidiaries.

3) Expanded Opportunity Sets

When companies expand their operations globally, they also benefit from increased opportunities that are available now. They can raise funds in a capital market where the cost of capital is the lowest. In addition, firms can also gain from enhanced economies of scale by expanding their operations globally.

4) Market Imperfections

The final feature of international finance that distinguishes it from domestic finance is the significant imperfections prevalent in today’s global markets. There are profound differences among nations’ laws, business practices, tax systems, and general cultural environments of different countries. Imperfections in the world financial markets hinder investors from fully diversifying their portfolios. Though there are risks and costs in coping with these market imperfections, they present to managers of international firms.

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Principles of International Finance

The financial manager has three major functions:

  1. Financial planning and control,
  2. The acquisition of funds, and
  3. The allocation of funds.

However, each of these three functions shares most principles of global finance and their relationships.

Seven important principles of global finance are given as follows:

1) Risk-Return Trade-Off

The maximisation of stockholders’ wealth depends on the trade-off between risk and profitability. Generally, the higher the project risk, the higher the expected return from the project. For example, if anyone is offered a chance to invest in a project that offers an extremely high rate of return, you should immediately suspect that the project is very risky. The risk-return trade-off does not apply to 100 per cent of all cases, but in a free enterprise system, it probably comes close. Thus, the financial manager must determine the optimal balance between risk and profitability to maximize returns.

2) Market Imperfections

Perfect competition exists when sellers of goods and services have complete freedom of entry into and exit any national market. Under such conditions, the mobility and transferability of goods and services would be unhindered. Unrestricted mobility fosters cost and return equality among nations. This cost-return uniformity everywhere in the world would eliminate the motivation for international trade and investment.

3) Portfolio Effect (Diversification)

The portfolio effect states that as more assets are added to a portfolio, the overall risk of the portfolio diminishes. This principle underscores the notion that diversification can lead to a reduction in risk. This principle explains much of the rationale for large MNCs to diversify their operations across industries, countries, and currencies. Some MNCs, such as Nestle of Switzerland,  have established operations in countries as varied as the United States, Mexico, Nigeria, Hong Kong, Japan, Russia, France, Brazil, Vietnam and North Korea. Because it is impossible to predict which countries will outperform other countries in the future, these companies are adopting a strategy of hedging their bets.

4) Comparative Advantage

Comparative advantage states that trade between the two countries can boost living standards in both. Trade allows countries to specialise in what they do best and to enjoy a wider array of goods and services. At the same time, companies earn profits from trade because individual companies conduct most trade transactions.

5) Internationalisation Advantage

The advantages of internationalisation influence companies to invest directly in foreign countries.

These advantages depend on three factors:

  1. Location,
  2. Ownership, and
  3. Internationalization

Exxon Mobil has ownership advantages, such as technology, marketing expertise, capital and brand names. Venezuela has location advantages, including vast crude oil reserves, a plentiful labour force, and favourable tax rates. The advantages of internationalization enable MNCs to enjoy superior earnings performance over domestic companies.

6) Economies of Scale

There are economies of scale in the use of multiple assets. Economies of scale are realized through a synergistic effect, which is said to exist when the whole is greater than the sum of individual components. When companies produce or sell their primary product in new markets, they may increase their earnings and shareholder’s wealth due to economies of scale. Companies can benefit from greater economies of scale when strategically allocating their tangible and financial resources globally. The expansion of a company’s operations beyond national borders allows it to acquire necessary management skills and effectively disseminate existing expertise across a broader operation.

7) Valuation

The valuation principle states that the value of an asset is equal to the present value of expected earnings. The value of an MNC is usually higher than the value of a domestic company for reasons:

  1. Research indicates that multinational corporations (MNCs) earn more profits than domestic companies.
  2. The earnings of larger companies are capitalised at lower rates.

The securities of multinational corporations (MNCs) generally possess superior marketability in comparison to domestic companies. MNCs are also better known among investors. These factors lead to a lower required rate of return and higher price-earning ratios. When MNCs attempt to maximise their overall company value, they also face various constraints. Those constraints that hamper an MNC’s ability to maximize its shareholders’ wealth encompass significant agency costs and environmental disparities.

Importance of Managing International Finance

International financial management deals with the financial decisions made within international business. The growth in international business is first of all, evident in the form of the highly inflated size of international trade.

The need for international financial management has increased because of the following factors:

1) Complex Financial Decisions

One of the reasons for the need for international financial management is the complexity of the financial decisions of MNCs. Today’s MNCs are more interested in maximising the value of global wealth. And to manage it quite well, international financial management helps a lot.

2) Lending of Funds

Another reason for the need is the vast magnitude of lending international and regional development tasks. The movement of funds from developed countries and the reverse movement of funds in the form of interest and amortisation payments need proper management.

3) Expansion Of Multinational Companies

By expansion of the operations of multinational companies, the cross-country flow of funds increased substantially. The two-way flow of funds, outward in the form of investment and inward in the form of repatriation divided royalty, and technical service fees requires proper management. And for doing it, efficient international financial management is a must.

4) Others

Some other points that emphasise the importance of international financial management are as follows:

  1. Increase in the volume of international trade.
  2. The globalisation of businesses.
  3. Increase in the movement of capital and labour with fewer restrictions.
  4. Increase in speed of communication and transport.
  5. The emergence of international capital and money markets.

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Nature of Financial Management