International Finance

Dr. Amrieta
International Finance
 A 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.

Dr. Amrieta
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.

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International Finance
 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.

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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 profit margins affected by
exchange rates which influence the dollar prices of
imported appliances.

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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

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Absolute Advantage theories
Number of units of factors of production required per unit
of final product
Coal Wheat
US 2 units/ton 1 unit/ton
Germany 1 unit/ton 4 units/ton

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.
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Doctrine of Comparative
Advantage
Number of units of factors of production required per unit
of final product
Coal Wheat
US 2 units/ton 1 unit/ton
UK 3 units/ton 4 units/ton

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.
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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.

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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.

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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
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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.
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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.

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Exchange Rate Equilibrium
 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.

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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.

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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.

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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.

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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

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