5/10/2017 IEBWireframe

1.1 WHATISSPECIALABOUTINTERNATIONALFINANCE?
Whilewemaybeconvincedoftheimportanceofstudyinginternationalfinance,wemuststillaskourselves,Whatisspecialaboutinternationalfinance?Putanotherway,how
isinternationalfinancedifferentfrompurelydomesticfinance(ifsuchathingexists)?Threemajordimensionssetinternationalfinanceapartfromdomesticfinance:

1.Foreignexchangeriskandpoliticalrisk
2.Differencesinregulations,taxlawandgovernmentpolicies
3.Thegreatersetofbusinessopportunitiesforproductionandinvestment

Aswewillsee,thesemajordimensionsofinternationalfinancereflectthefactthatsovereignnationshavetherightandthepowertoissuetheirowncurrencies,toformulate
theirowneconomicpolicies,toimposetaxes,andtoregulatethemovementofgoods,servicesandcapitalacrosstheirborders.Beforemovingon,itisusefultobrieflyillustrate
eachofthesekeydimensionsofinternationalfinancialmanagement.

ForeignExchangeandPoliticalRisk
AnimportantCanadianexporttoMexicoiscanola,ageneticallyengineeredoilseedproducedintheprairieprovinces.Canadianexportersofcanola,suchasAdvantaSeeds
ofWinnipeg,arevulnerabletochangesintheexchangeratebetweentheCanadiandollarandthecurrencyofthenationtowhichtheyareexporting,inthiscaseMexico.Ifthe
MexicanpesoweretodepreciatesharplyagainsttheCanadiandollar,asitdidinthefamousTequilacrisisof1994,thepesopriceofcanolawouldimmediatelyrise.Advanta
SeedswouldseesalesoftheproductdropasitbecomesmorecostlyforMexicans.
Page4
Therewouldbelostsalesandlowerprofits,allduetoanunexpectedchangeintheCanadiandollarMexicanpesoexchangerate.Theriskofsuchlossesisforeignexchange
risk.
AdvantaandotherCanadianexportsfacedsimilardifficultyinthewakeoftheAsianfinancialcrisesof1997whenthevalueoftheThaibaht,theKoreanwonandtheMalaysian
ringgitallfellsharplyagainstothercurrencies,includingtheCanadiandollar.Whenfirmsareinvolvedinforeignsales,theyarepotentiallyexposedtoforeignexchangeriskofa
sortnotnormallyencounteredinpurelydomestictransactions.
Inourmodernworldofflexibleexchangerates,theratesfluctuatecontinuouslyinunpredictableways.Thishasbeenthecasesincetheearly1970s,whenaregimeoffixed
exchangeratesamongthemajorcurrenciesincludingtheUSdollar,theBritishpound,theJapaneseyenandtheGermandeutschemarkwasabandoned.Canada,priorto
thatmove,wasuniqueamongnationsforallowingtheCanadiandollartofloatagainsttheUSdollar,althoughinaverynarrowrange.
Exhibit1.1illustratesthatourexchangeratevolatilityincreaseddramaticallyafter1973.Noteinparticulartherelativelylowvolatilitybetween1962and1970followedby
substantialvolatilitythereafter.Atthefarrighthandsideofthegraph,theextraordinaryspikesofthemonthlychangesdownwardspikesareappreciationoftheCanadian
dollar,whileupwardspikesaredepreciationgraphicallydepicttheheightenedexchangeratevolatilityoverthepastdozenyears.Theextremeupwardspikeoccurredin
October2008,thefrenziedstartofthecontinuinginternationalfinancialturmoil.Inthatmonth,theCanadiandollardepreciated12percentagainsttheUSdollar.

EXHIBIT1.1
CanadaUSExchangeRate:MonthlyPercentageChanges,19502013
Source:InternationalMonetaryFund,InternationalFinancialStatistics,variousissues(Washington,DC).

Exchangeratevolatilitycreatesabumpyroadforinternationalbusiness.Therearewaystoaddresstheupsanddowns,andthisbookwillillustrateeffectivetechniquesand
strategies.
Anotherformofriskthatfirmsencounterinaninternationalsettingispoliticalrisk.Politicalriskrangesfromunexpectedchangesintaxrulestooutrightexpropriationofassets
heldbyforeigners.Politicalriskarisesfromthefactthatasovereignnationcanchangetherulesofthegameandtheaffectedpartiesmaynothaveeffectiverecourse.Wecan
continuewiththeexampleofCanadianexportsofcanolatoillustratepoliticalrisk.Asageneticallyengineeredagriculturalproduct,canolaissuspectinsomecountries.In2002,
Chinabannedtheimportofcanola,wipingouta$200millionmarketforCanadianproducers.
Page5
Canadain1997passedlegislationbanningthegasolineadditiveMMTfromimportationintoCanada,offeringanotherillustrativecaseofpoliticalactionthatpenalizeda
multinationalenterprise.TheEthylCorporation,aUSownedimporterofMMTintoCanada,challengedthelegislationunderNAFTAChapter11,thesectionthatdefinesthe
limitsofgovernmentactionthatadverselyaffectsforeignfirms.TheGovernmentofCanadasettledtheclaimoutofcourt,paying$13milliontoEthyl,includingthefirm'scosts
andlostprofits.EthyldroppeditsclaimsagainsttheGovernmentofCanada.Thecaseillustrateshowinternationalagreements,suchasNAFTA,canmitigatepoliticalriskby
providingameansbywhichforeigncompaniescanseekrecourse.However,theEthylcasealsocausedalarmoverwhethertheprovisionsofNAFTAcouldbeusedtolimit
sovereignpowersofregulationinthefieldsofenvironmentandpublichealth.

MarketImperfections
Althoughtheworldeconomyismoreintegratedtodaythanitwas10or20yearsago,avarietyofbarriersstillhamperfreemovementsofgoods,servicesandcapitalacross
nationalboundaries.Thesebarriersincludetraderestrictions,transportationcostsanddiscriminatorytaxation.Worldmarketsarethusimperfect.Aswewilldiscuss
later,marketimperfectionsrepresentfrictionsthatpreventmarketsfromfunctioningeffectively,andtheyplayaroleinmotivatingmultinationalcorporations(MNCs)tolocate
productionabroad.Honda,theJapaneseautomobilecompany,forinstance,establishedproductionfacilitiesinAlliston,Ontario,mainlytocircumventa6.1percenttaximposed
byCanadaonimportedfinishedvehicles.Insuchcases,foreigninvestmentisaproductofmarketimperfections.
Imperfectionsinworldfinancialmarketstendtorestricttheextenttowhichinvestorscandiversifytheirportfolios.AninterestingexampleinvolvestheNestlCorporation,the
wellknownSwissMNC.Nestlusedtoissuetwodifferentclassesofcommonsharesbearersharesandregisteredshares.Foreignerswereallowedtoholdonlybearer

http://textflow.mheducation.com/parser.php?secload=1.1&fake&print 1/2
5/10/2017 IEBWireframe
shares.AsExhibit1.2shows,priorto1988bearersharestradedforabouttwicethepriceofregisteredshares,whichwereexclusivelyreservedforSwissresidents.1 Theprice
disparityisauniquelyinternationalphenomenonattributabletoamarketintervention.

EXHIBIT1.2
DailyPricesofNestl'sBearerandRegisteredShares
Source:ReprintedfromJournalofFinancialEconomics,Volume37,Issue3,ClaudioLodererandAndreasJacobs,TheNestlCrash,pp.315339,1995,withkindpermissionfromElsevierScience
S.A.,P.O.Box564,1001Lausanne,Switzerland.

On18November1988,however,Nestlliftedrestrictionsimposedonforeigners,allowingthemtoholdregisteredaswellasbearershares.Afterthisannouncement,theprice
spreadbetweenthetwotypesofNestlsharesnarroweddramatically.Thepriceofbearersharesdeclinedsharplywhereasregisteredsharesrosesharply.Theresultwasa
transferofwealthfromforeignshareholderstoSwissshareholders.ForeignersholdingNestlbearershareswereexposedtopoliticalriskinacountrythatiswidelyviewedasa
havenfromsuchrisk.TheNestlepisodeillustratesboththeimportanceofconsideringmarketimperfectionsininternationalfinanceandtheperilofpoliticalrisk.
AboutthesametimeastheNestlcase,studiesontheinternationalintegrationofCanada'sfinancialmarketsmadeacompellingargumentthatCanadiantaxpoliciesand
restrictionsonforeigninvestmentweresegmentingCanadafromtherestoftheworld,financiallyspeaking.TitlessuchasTheWedgeoftheWithholdingTax(Brean1984),
Taxes,FundsPositioningandtheCostofCapital(Booth1987),andTheForeignPropertyRule:ACostBenefitAnalysis(Burgess2005)illustratetheeffortsofpolicyanalysts
toidentifyhowinterventionsdistortinternationalincentives,setthestageforshadowyarbitrageandaregenerallycostlytoCanadaduetotheinvestmentandfinancial
inefficienciesthattheycause.Fortunately,thesesortsofstudieseventuallyhadimpact.Itisaccuratetosaythatwithvariousbarriersremoved,Canada'scapitalmarketsare
moreinternationallyintegratedtodaythaneverbefore.
Page6

ExpandedOpportunitySet
Whenfirmsengageinbusinessbeyondtheirownnationalborders,whentheybecometransnationalormultinational,theybenefitfromanexpandedopportunityset.When
firmslocateproductionabroad,whentheypenetrateforeignmarketsortapthecapitalmarketsofothercountries,theyareoperatinginaglobalcontext.Firmswithaglobal
perspectivescantheworldforinvestmentopportunities,forlowcostresourcesandforforeignmarketstodevelop.
FourSeasonsHotels,aworldleaderinthehighendhospitalitysector,beganlifeinToronto.ItlaterexpandedtoParis,NewYorkandMilanamongothercitiesasFourSeasons
grewtoglobalprominence.Similarly,McCainFoodsofNewBrunswicknowoperatesinmorethan30countries.WhileMcCainisprimarilyassociatedwithFrenchfries
producingonethirdofallfrozenFrenchfriesintheworldMcCainisactuallyexportingitstechnologyandmanagerialskill.WhenCN,formerlyCanadianNational,was
developingastrategyforgrowth,itboughttwoMidwesternAmericanrailwaycompaniesandrestructuredCNfromaneastwestCanadianrailwaytoacontinentallogistics
system.WhenBarrick,theTorontobasedminingcompany,looksforexplorationandproductionopportunities,itlookstoAustralia,Peru,ChileandTanzania.WhenBarrick
raisescapitalforthesecapitalintensiveactivities,itissuessharessimultaneouslyinToronto,NewYork,London,ParisandZurich.
ThesewellknownCanadiancompaniesillustratethesuccessfulidentificationandpursuitofexpandedopportunitiesineachoftheirrespectiveindustries.However,theirroots
areinCanada,justastherootsofRootsCanadaareinCanada,butitsbusinessperspectiveandgrowthprospectsareglobal.
Individualinvestorscanalsobenefitiftheyinvestinternationally,ratherthandomestically.Supposeyouhaveagivenamountofmoneytoinvestinshares.Youmayinvestthe
entireamountinCanadian(domestic)shares.Alternatively,youmayallocatethefundsacrossdomesticandforeignshares.Ifyoudiversifyinternationally,theresulting
internationalportfoliomayhavealowerriskorahigherreturn(orboth)thanapurelydomesticportfolio.Thiscanhappenmainlybecausesharereturnstendtocovarymuch
lessacrosscountriesthanwithinagivencountry.Onceyouareawareofoverseasinvestmentopportunitiesandarewillingtodiversifyinternationally,youfaceanexpanded
opportunityset.Itmakesnosensetoplayinonlyonecornerofthesandbox.
1BearerandregisteredsharesofNestlhadthesameclaimsondividendsbutdifferentialvotingrights.Chapter16providesadetaileddiscussionoftheNestlcase.

http://textflow.mheducation.com/parser.php?secload=1.1&fake&print 2/2