an overview of international finance

1. Multinational Financial
Management
International Corporate Finance
P.V. Viswanath

2. P.V. Viswanath 2
The Multinational Enterprise
 A multinational corporation is a company engaged in
producing and selling goods or services in more than one
country. Usually, it consists of a parent company located in
the home country and several foreign subsidiaries.
 A multinational is characterized more by attitude than the
physical reality of an integrated system of marketing and
production activities worldwide.
 “Where in the world should we build our plants, sell our
products, raise capital, and hire personnel?” i.e. a global
perspective, rather than the perspective of the home country,
where the parent is located.

3. P.V. Viswanath 3
Relevance of International Finance
 Many of the problems of multinational firms are due to the
use of different currencies used in different countries and the
consequent need to exchange them.
 There are political divisions as well as currency divisions
between countries.
 A financial manager has to decide how international events
will affect a firm and what steps can be taken to exploit
positive developments and insulate the firm from harmful
ones.

4. P.V. Viswanath 4
Relevance of International Finance
 Relevant variables are changes in exchange rates,
interest rates, inflation rates and asset values.
 However, these variables are interconnected.
 Hence foreign exchange risk is not simply added to
other business risks. The amount of risk depends
crucially on the way exchange rates and other
financial prices are connected.

5. P.V. Viswanath 5
Relevance of International Finance
 Even companies that operate only domestically but
compete with firms producing abroad and selling in
their local market are affected by international
developments.
 Thus, US appliance manufacturers with no overseas
sales will find US sales and proift margins affected
by exchange rates which influence the dollar prices
of imported appliances.

6. P.V. Viswanath 6
Outline
 Basis for international trade
 We will look at why there is international trade and on
what basis trade occurs, i.e. who exports what to whom.
 How multinationals fit into the traditional theory
 What is the role of multinationals in international trade

7. P.V. Viswanath 7
Doctrine of Absolute Advantage
Coal Wheat
US 2 units/ton 1 unit/ton
Germany 1 unit/ton 4 units/ton
Number of units of factors of production required per unit
of final product
Since the US is more efficient in the production of wheat, it will produce
wheat; Germany is more efficient in the production of coal; hence it will
produce coal. The US will export wheat to the Germany and import coal.
Assumptions: 1) Factors of production cannot move freely across countries.
2) Factors of production are not specialized.

8. P.V. Viswanath 8
Doctrine of Comparative Advantage
Coal Wheat
US 2 units/ton 1 unit/ton
UK 3 units/ton 4 units/ton
Number of units of factors of production required per unit
of final product
Even though the US is more efficient in the production of both
wheat and coal, it has a comparative advantage in the production
of wheat; hence, it will produce wheat; the UK has a
comparative advantage in producing coal; hence it will produce
coal. The US will export wheat to the UK and import coal.

9. P.V. Viswanath 9
Gains from Trade
 Prior to the introduction of trade, the exchange rate between wheat and
coal in the US and UK must be as follows:
US 1 ton wheat = 0.5 tons of coal
UK 1 ton wheat = 1.33 tons of coal
Clearly, UK producers of coal will find it advantageous to sell their coal to
the US, since they can get more than 0.75 tons of wheat for each ton of
coal. Similarly, US producers of wheat can get more if they sold to the UK
than the 0.5 ton of coal they could get in the US. Hence, the final terms of
trade, i.e. the common exchange rate after trade is introduced will be
somewhere between the two exchange rates, above. For example, it might
be 1 ton of wheat = 1 ton of coal. Exactly where it will be, will depend
upon the demand and supply schedules for coal and wheat.

10. P.V. Viswanath 10
Specialized Factors of Production
 If some factors are specialized, i.e. relatively more efficient
in the production of one commodity rather than the other,
the prices of the factors that specialize in the commodity that
is exported will gain because of greater demand, once trade
begins.
 This is because demand for a factor is a derived demand and
is based on demand for the goods that the factors produce.
 US producers of coal that cannot switch to wheat production
will be hurt, since the demand for their product will drop.
 The greater the gains from trade for a country overall, the
greater the cost of trade to those factors of production that
specialize in producing the commodity, now imported.

11. P.V. Viswanath 11
Monetary Prices and Exchange Rates
 Suppose before the start of trade, each production unit costs $30
in the US and £10 in the UK. Then the prices of wheat and coal
in the two countries will be:
Coal Wheat
US $60/ton $30/ton
UK £30/ton £40/ton
After trade begins, terms of trade will equalize between countries; we
can have any rate of exchange between 1 wheat: 0.5 coal or 1:1.33.
Suppose the terms of trade are 1:1. This is consistent with the within-
country prices given below.
Coal Wheat
US $30/ton $30/ton
UK £30/ton £30/ton

12. P.V. Viswanath 12
Monetary Prices and Exchange Rates
 What about the exchange rate? Suppose the exchange rate were
$3 = £1, then the dollar-equivalent prices would be:
Coal Wheat
US $30/ton $30/ton
UK $90/ton $90/ton
At these prices, all coal and wheat would be produced in the US
and exported to the UK. Factors of production in the UK would
be idle and the UK will have a massive trade deficit. The US
will be prosperous and the UK will have massive unemployment
and depression.
Obviously, such a situation cannot continue; it is not an
equilibrium situation.

13. P.V. Viswanath 13
Exchange Rate Equilibrium
 The British demand for dollars to buy US wheat and coal will raise
the value of the dollar. This will make US products more expensive
to the British and British goods less expensive to Americans.
 This will continue until the exchange rate stabilizes at $1 = £1, which
is an equilibrium rate.
 If factors of production are specialized, then the jump in demand for
US factors of production will raise their prices and hence the cost of
producing US coal and wheat will rise.
 British products will become more attractive to Americans and
American products will become less attractive to the British.
 This process will continue until both countries find their comparative
advantage and the terms of trade between coal and wheat are equal in
both countries. The exchange rate will also have to adjust so that
dollar costs of production are equalized across countries.

14. P.V. Viswanath 14
Factor Price Equalization
 The shift in the demand for factors of production in
the two countries should cause factor prices to
equalize.
 However, this will happen only if free trade is not
impeded.
 If trade is not free, i.e. goods and services cannot
move across borders, factors of production may
move, if permitted.

15. P.V. Viswanath 15
The Role of the Multinational Firm - I
 Does the Multinational Corporation represent
movement of capital?
 The theory of comparative advantage rests on factor
differences across countries. However, when
countries become increasingly homogenous, other
factors might determine trade.

16. P.V. Viswanath 16
The Role of the Multinational Firm - II
 Economies of scale might require a transnational
entity.
 Improved communications permit intermediate
commodities to be traded – the example of the Barbie
doll.
 Cultural predilections, historical accidents and
government policies, differences in attitudes to
labor/unions.
 Development of International Finance – raising capital
abroad, sharing risk across borders, tax arbitrage, need
for diversification.

17. P.V. Viswanath 17
Financial Issues for the Multinational
Firm
 foreign exchange risk management
 managing working capital and the internal financial
system
 financing foreign units
 capital budgeting
 evaluation and control