Table of Contents:-
- Meaning of International Finance
- Nature of International Finance
- Principles of International Finance
- Importance of Managing International Finance
Meaning of International Finance
International finance is a specialized field of economics that studies the dynamics of exchange rates, foreign investment, and their profound impact on international trade. It is a field of study that delves into various aspects of global financial systems such as international projects, investments, capital flows, and trade deficits. The field of international finance 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 dedicated to the study and analysis of institutions, practices, and cash flows between different countries. There are several prominent differences compared to its purely domestic counterpart, the most important one is the presence of exchange rate risk. Exchange rate risk refers to the uncertainty that arises in international financial decisions that result from changes in the value of one country’s currency relative to another country’s currency.
Various factors set apart one situation from another, and these distinctions can impact the decisions surrounding foreign investment. For example, the environment in which direct foreign investment takes place plays an important role. Additionally, changes in the political environment can introduce new risks that need to be carefully considered.
Nature of International Finance
International finance is a unique and specialized area of study that possesses several distinctive characteristics, setting it apart from other fields.
The important differentiating features of international finance are explained as follows:
- Foreign Exchange Risk
- Expanded Opportunity Sets
- Political Risk
- Market Imperfections
1) 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 the presence of a single national currency that acts as the primary medium of exchange within a country. 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 not only in countries where it is currently doing business but also where they expect to establish subsidiaries.
3) Expanded Opportunity Sets
When companies expand their operations globally, they also tend to benefit from expanded opportunities that are available now. They can raise funds in 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, tax systems, business practices and general cultural environments. 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.
- nature of business meaning
- nature of international business
- scope of international marketing
- determinants of economic development
- nature of capital budgeting
- nature of international marketing
Principles of International Finance
The financial manager has three major functions:
- Financial planning and control,
- The acquisition of funds, and
- 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 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 risk of a project, 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 attempt to determine the optimal balance between risk and profitability that will maximise
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 not only across industries but also across 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 most trade is carried out by individual companies.
5) Internationalisation Advantage
The advantages of internationalisation influence companies to invest directly in foreign countries.
These advantages depend on three factors:
- Ownership, and
Exxon Mobil has ownership advantages, such as technology, marketing expertise, capital and brand names. Venezuela has location advantages, such as crude oil, abundant labour and low taxes. 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 many assets. Economies of scale occur as a result of a synergistic effect, which is said to exist when the whole is greater than the mere sum of its parts. 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 gain from greater economies of scale when their real capital and monetary assets are deployed on a global basis. 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.
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:
- Studies show that MNCs earn more profits than domestic companies.
- The earnings of larger companies are capitalised at lower rates.
The securities of multinational corporations (MNCs) have better marketability compared to those of 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 the realm of 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.
Some other points that emphasise the importance of international financial management are as follows:
- Increase in the volume of international trade.
- The globalisation of businesses.
- Increase in the movement of capital and labour with fewer restrictions.
- Increase in speed of communication and transport.
- The emergence of international capital and money markets.
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