Chapter 6: International Financial Management

Globalization and The Multinational Corporation

Globalization has affected the culture, the social, and economic structure of nearly all of the societies. It is a fact that the globalization phenomenon has been originated mainly from the trade activities between nations.

The evolution of trade openness dramatically increased trade flows between countries. Figure 6.1(page 127) presents the world trade volume since 1948. It is apparent that the trade has stepped up especially after the 2000s.

The realization of foreign trade requires the realization of the payment in exchange for the goods imported. These are two sides of a coin, and this explains the development of a worldwide financial system. It is a fact that globalization creates different types of risks to be managed operationally and financially for all the firms whether operating in a national or international environment.

International Financial Flows

International financial flows are created through several means, the most important of which are international trade and investments. The fund’s movements are defined by the relationships between the economic agents of different countries, state, and foreign governments and international organizations. The types of international financial flows can be classified according to the economic activity according to the structure of the balance of payments, the economic relationship between the non-residents, the terms of financial transactions, and the form of ownership of the sources of financial flows as figured out in Figure 6.2.on page 128.

The amount and direction of financial flows depend on various factors, including but not limited to the following factors:

• the condition of the global economy.
• the size of the international trade barriers;
• different rates of economic development of the countries (synchrony or asynchrony in the major countries’ economies);
• the differential break of inflation’s rate and the level of interest rates,
• the increase of balance of payments’ deficits due to the imbalance of international payments.

The International Settlements

The international settlements create the system of adjusting of payments of money claims and obligations that arise between the subjects of international economic activity, based on political, economic, scientific, technical, and other relations, and they are represented in the balance of payment account of a country.

The international settlements are mainly sourced by two main types of transactions between countries:

• the commercial payments of money claims and obligations related to international trade, international loans, and foreign direct investments etc.
• the non-commercial payments, related to the transport of passengers, insurance, tourism, and the transfer of funds abroad etc.

Multinational Corporations

A multinational corporation (MNC) consists of a parent company in the firm’s resident country and the operating subsidiaries, branches, and affiliates it controls both at home and abroad. Although there can be various types and structures of an MNC, there are four categories of multinationals that exist. They include:

• A decentralized corporation with a strong presence in its home country
• A global, centralized corporation that acquires a cost advantage where cheap resources are available
• A global company that builds on the parent corporation’s research and development efforts
• A transnational enterprise that uses all three categories mentioned above

The Types of Multinational Corporations

Generally, the multinational corporations can be established as horizontally or vertically integrated corporations or as conglomerates, each of which is defined below:

• Horizontally integrated multinational corporation involves the production of essentially the same product in different countries.
• Vertically integrated multinational corporation commences various stages of production in different countries.
• Conglomerate multinational corporation produces a different range of products in different countries.

Characteristic of Multinational Corporations

The characteristics of the multinational corporations are:

• Efficiency
• Big Size
• International Operation
• Oligopolistic Structure
• Collective Transfer of Resources
• Development

Entry Strategies to International Operations

Once a firm has decided to go into the international arena, it must make a choice regarding the appropriate organizational mode for organizing its foreign business activities. There are a number of entry strategies available and these are not mutually exclusive, indeed, large companies may employ them simultaneously in different contexts. These modes vary in terms of the risk they involve. They also differ in terms of their organizational, management and resource demands as well as the amount of control that can be exercised over foreign operations as defined below:

• Exporting
• Franchising
• International Joint Venture (IJV)
• Fully Owned Subsidiaries

Management of Multinational Corporation

A well-diversified MNC can actually reduce risks and fluctuations in earnings and cash flows by making the diversity in geography and currency work in its favor. However, the management of a multinational corporation requires management of risks associated with the multiplicity of currency, culture, and operations.

Political risk relates to the additional possibility of losses on private claims and also on direct investment.

Sovereign risk, on the other hand, relates to the possibility of losses on claims to foreign government or government institutions in the form of bonds and loans.

The Foreign Exchange Market

The foreign currency or foreign exchange market (FOREX market) is the decentralized worldwide market in which currencies are traded. It is occasionally created in order to facilitate the flow of money derived from international trade.

Clearinghouses take the opposite position of each side of a trade. When two parties agree on the terms of a transaction, a clearinghouse sits in the middle, acting as both the buyer and the seller. Clearinghouses exist to ensure the smooth functioning of financial markets.

The FX market is known for its great variety of participants ranging from central banks to private individuals, and for the large number of currencies that are traded.

As Figure 6.3 (page 135) presents, there exist two interconnected foreign exchange markets, the first one constitutes the world’s major banks, and other financial institutions that make up the interbank market that act as the wholesale part of the forex market where banks manage inventories of currencies.

Special Currency Exchange Rates

In order to make economic assessments, several types of foreign exchange rates are used (Kozak, 2015):

• Nominal Exchange Rate
• Real Exchange Rate
• Nominal Effective Exchange Rate

Determinants of the Exchange Rate

Important three approaches that explain the foreign exchange are expressed below:

• The Balance of Payments is an accounting system that tries to capture a country’s transactions with the rest of the world.
• The Law of One Price assumes that arbitrage should ensure that the price of any good or service is the same everywhere.
• Purchasing Power Parity (PPP) proposes that the average Purchasing Power of different currencies should be the same which means the cost of living should the same after converting currencies.( Determinants of Foreign Exchange Rate are shown on page 137,Figure 6.4)

Structure of Foreign Exchange Market

In the liquid markets, there are large numbers of buyers and sellers, and transaction costs are low. The foreign exchange markets for the major currencies, such as the markets for the U.S. dollar, the euro, the Japanese yen, and the British pound, are among the most liquid markets in the World.

The bid price is always less than the ask price because of the trader bids for the base currency when they buy it, and asks a price for the base currency when they sell it.

Functions of Foreign Exchange Market

The principal functions of the foreign exchange market are the following:

• To set the prices of some currencies with respect to others (currency pairs).
• To allow for the realization of currency risk coverage, for example, when investments are made in another currency.
• To favor the exchange of funds between different countries which have excess liquidity and which are in need of foreign currency liquidity.
• To finance international trade, whose transactions represent a significant part of the currency market.

Types of Contracts Traded

Different types of trades can be conducted in the foreign exchange market. There exist two specific dates for each transaction; these are transaction date and the value date which implies the date when the real exchange of money takes place.

A derivative security is a financial instrument whose value depends upon the value of another asset.

Foreign Exchange Rate Risk Three main types of exchange rate risks are (Papaioannou,2006):

1. Transaction risk
2. Translation risk
3. Economic risk

Measurement of Foreign Exchange Rate Risk

The risk measurement can be realized by a widely used model; Value-at-Risk (VaR). The model is based on the concept of value at risk which is defined as the maximum loss for a given exposure over a given time horizon with z% confidence.

• The VaR calculation depends on three parameters:
• The holding period
• The confidence level at which the estimate is planned to be made.
• The unit of currency to be used for the denomination of the VaR.

Management of Exchange Rate Risk

There exist several techniques to manage exchange rate risk by using the hedging instruments provided by the international money and capital markets; however, each hedging strategies have its costs attached. The available hedging instruments are enormous, both in variety and complexity, all of which are developed referring to the hedging needs of the sovereign, banks and corporate. Amongst the most widely used currency hedging instruments are currency forwards, futures and crosscurrency swaps.

International Capital Markets

The global financial system promotes economic growth by several means:

• facilitating specialization and promoting trade;
• mobilizing resources globally;
• increasing the set of opportunities available to companies, entrepreneurs, and individuals to participate in and contribute to global economic growth.
• facilitating risk management,
• obtaining information for the evaluation of businesses and allocating capital.

Capital Market Participants

The primary issuers of capital market securities are governments and corporations. The government needs long-term funding in order to finance infrastructure and other projects as well as budget deficits. The corporation’s issue both bonds and stock and this has been known as most deterministic funding decision to issue bonds or stocks.

Capital Market Trading

Capital market trading activities take place in either the primary market or the secondary market. The primary market is where new issues of stocks and bonds are firstly sold to the investors. A secondary market is where the sale of previously issued securities takes place, and it is important because most investors plan to sell long-term bonds before they reach maturity and eventually to sell their holdings of stock. There are two types of exchanges in the secondary market for capital securities: organized exchanges and overthe-counter exchanges.

The Bond Market

Bonds are securities that represent a debt owed by the issuer to the investor. The specific characteristics of a bond are defined below:

• The par, face, or maturity value of the bond is the amount that the issuer must pay at maturity.
• The coupon rate is the rate of interest that the issuer must pay periodically. The coupon rate may be set as a fixed rate for the duration of the bond or a floating rate.

The international bond market is divided into three bond market groups:

• Domestic bonds.
• Foreign bonds.
• Eurobonds.

Credit Ratings

The credit ratings are based on an analysis of current information regarding the likelihood of default and the specifics of the debt obligation. A sovereign credit rating is the credit rating of a country or sovereign entity, and it gives an indication about the risk level associated with investing in a particular country, including its political risk.

International Financial Management

The goal of financial management is to maximize the value of a company and profit and risk are the key parts of the financial management. The financial management aims to increase the long-term profitability of a company and increase the ability to perform its financial obligations to other firms and organizations, as well as to the government.

International Financial Management, in addition to common financial management tasks, solves a number of specific objectives:

• the planning of financial transactions from the perspective of international payments in different currencies;
• financing the export activity;
• international capital budgeting, the motivation of direct and portfolio investment.