In this lesson, you’re expected to learn about:
– international currency
– considering the opportunities and risks of international investments
– sourcing capital and distributing products globally
As advances in global communication, information and transportation occur, simply remaining domestically-minded is no longer sufficient, because ‘sticking your head in the sand’ does nothing more than blind you to the manner in which businesses around the world are already influencing your own company and your own life.
This lesson discusses some of those things that are uniquely related to international finance.
Nations keep track of all the trades they make in their balance of payments, with the two primary accounts being:
1) Current Account
Measures the amount of consumable goods entering or leaving a country. (The current account is what people are referring to when they discuss trade deficits and surpluses.)
These goods may include food, cars, machinery, customer service or anything else being purchased. A current account deficit means that a nation imports more goods than it exports and a current account surplus indicates that a nation exports more goods than it imports.
2) Capital Account
Consists of investments one nation makes in another nation’s economy, such as the value of new business start-ups, the value of stocks, shares and bond purchases, and even the transfer of money related to imports and exports.
So when Nation A exports goods to Nation B, it does so with the expectation that it will later trade the currency Nation B gives it for a greater amount of resources than Nation B gave it this time. In other words, the whole process of exporting is an investment.
An increase in one of these accounts always results in a decrease in the other. So when a nation has a current account deficit, it also has a capital account surplus.
A nation can sustain a current account deficit as long as the people of other nations are confident that they’ll be able to use the currency they receive for their exports to purchase other goods and services from the importing nation or other nations interested in the importing nation’s currency.
The real issue is whether or not the value of the nation’s exports is going to increase over time relative to the value of its imports. A nation wants to know whether all the money it’s spending will boost the total value of its productivity in a manner that allows it to meet its export obligations later (because other nations now hold its currency) while still maintaining enough production to meet domestic demand, and whether companies are treating imports as capital investments or mere consumption.
The purchasing power of a nation’s currency refers to that nation’s ability to purchase goods. Usually purchasing power is measured using a list of necessities, such as groceries, utilities and other requirements for daily life.
Purchasing power by itself doesn’t really mean anything, but when used to track changes over time, it helps measure inflation. For example, if the price of beer goes up from £100 per keg to £101 in a year, the nation experiences 1% inflation that year.
Purchasing Power Parity
Purchasing power also comes into play when you’re comparing the ability of your money to buy something in your home country and the ability of a foreign currency to buy the same thing in the foreign nation. This comparison is called purchasing power parity (PPP).
For example, if £100 buys a keg of beer in the UK, but that exact same keg of beer bought in the US costs $124, the PPP of the dollar in the US to the pound in the UK is £100 = $124
(i.e. £1 = $1.24).
Probably the most famous way of measuring PPP is by using the Big Mac Index (published in The Economist). This Index uses the price of a McDonald’s Big Mac in every nation to determine PPP.
Exchange rate, on the other hand, refers to how much foreign money you can buy with your money. For example, currently 1 USD gets you €0.85.
Note that the exchange rate is different from the PPP. If a nation has a very low exchange rate (such that you can buy a lot of its money cheaply), but the PPP in that nation is higher than your country’s PPP, the two measurements tend to balance each other out as far as exports go.
For instance, if the US has a purchasing power 1% higher than the UK and an exchange rate 1% lower than the UK, US prices would be the same as UK prices for any pound that you exchange into dollars.
Understanding the Relationship between Interest & Exchange Rates
Particularly if you manage a multinational company, anticipating fluctuations in exchange rates can be an extremely important part of your company’s financial management success. So what influences exchange rates?
The International Fisher Effect (IFE; a hypothesis in international finance) says that for every 1% variation that a nation has in its nominal interest rates (that is, interest rates before adjustments are made for inflation) over another nation, the currency of that nation experiences a 1% decrease in exchange rate via inflationary pressures associated with increased interest, increased consumption and investment speculation.
For example, if the UK has an interest rate of 10% and Germany has an interest rate of 11%, according to the IFE, the exchange rate of the Euro drops by 1% relative to the UK pound. This drop occurs because the UK’s relatively lower interest rates stimulate consumption and capital investment in the nation, causing inflationary pressure to depreciate the value of the currency to foreign investors and foreign traders.
That being said, the IFE is more of a ‘jumping-off point’ intended to prove a point, and more elaborate models based on it have improved accuracy and usefulness. The IFE tends to hold true only in cluster formation (that is, small groups or bunches) soon after the interest rate differential occurs, because a change in interest rates happens only once whereas exchange rates are in a continuing state of fluctuation, and so you end up seeing a J curve when you graph the two rates. (With the J curve, the exchange rate drops at first before rising up higher than the original point, forming a J shape when graphed.)
This pattern occurs as the exchange rate goes down at first but then goes back up as the lower exchange rate and devalued currency causes a nation’s exports to be relatively cheaper for people in other nations, attracting more trade in the long run.
Spot Rate & Other Currency Transactions
A number of things influence exchange rates, but in the end, how are exchange rates decided when a floating currency is involved?
The process actually works a lot like buying shares. The organizations that have foreign currency and are willing to sell it for domestic currency (or another foreign currency) tell people how much of the domestic currency they want to receive for their foreign currency (i.e. the ask price). For example, the organizations may ask for 1.5 of the domestic currency for every 1 of their foreign currency.
When people want to buy that foreign currency, the amount they’re willing to pay for it is called the bid price. For example, a person may bid 1.3 of the domestic currency for every 1 of the foreign currency. The difference between the ask price and the bid price is called the spread, and no exchange can take place until buyer or seller (sometimes both) compromises on the final transaction price.
The price that’s agreed upon in this type of transaction is called the spot rate, because it’s the exchange rate that occurred right there on the spot. The majority of all foreign exchanges in which individuals participate are spot exchanges.
For example, in all major international airports, you can exchange money in foreign exchange booths, where you get the spot rate of exchange.
1) Currency Swaps: These exchanges occur when two organizations agree to exchange currency with each other and then exchange back at a later date, typically at the same rate. This arrangement allows each organization to have some foreign currency on hand for temporary use without foreign exchange risk. When available, swaps are extremely effective at mitigating risk.
2) Future and Forward Transactions: These exchanges are contracted to take place in the future at a price agreed upon immediately, giving a guaranteed transaction rate regardless of what happens to the market rate between the contract signing and the delivery date. The difference between forward transactions and future transactions is primarily that futures are standardized contracts that are traded in a similar way to stocks and shares, whereas forward transactions are individually customized between the parties of the transaction.
3) Options Contracts: Some companies prefer to purchase options contracts, which give them the option to buy or sell a currency at a specific rate but doesn’t oblige them to do so.
Diversifying Can’t Completely Eliminate Risk Exposure
Diversifying your investments means buying stocks and shares in several different companies. In an ideal world, if one of those companies does poorly the others mitigate your losses. But even this strategy can’t eliminate systematic risk (from the fact that any given nation’s market constantly jumps around in different directions).
For instance, if you were to buy up all the same shares in the FTSE 100, the value of your portfolio increases and decreases exactly the same as the overall FTSE 100. Despite diversifying your portfolio, you’re still vulnerable to systematic risk.
For this reason, some investors look to other nations to mitigate risk. After all, on many occasions one nation’s markets are crashing while another’s economy is booming.
Risk of Investing Internationally
Investing internationally, however, has its own inherent risks not otherwise found in traditional equity investing. Here are just a few of them:
1) Foreign exchange risk: Foreign equities are denominated in the currency of their nation, and so even when the value of your equity stays the same, if the exchange rate drops your investment is worth less to you.
2) Foreign regulations: These regulations may restrict you from taking your money out of the country.
3) Political instability: The government may fall apart altogether after a rebel coup. Or a nation in which you have investments may have culturally engrained nepotism or corruption within executive management that results in poor competitiveness.
Cross-Listing Allows Companies to Tap the World’s Resources
As companies reach out in search of capital to fund start-ups and expansion, they often look beyond their own borders for investors and lenders. Here are the three main reasons why:
1) Domestic availability of capital is limited and can be relatively homogeneous.
2) Issuing bonds abroad increases a company’s access to the number and types of lenders interested, reducing the amount of interest the company has to pay to attract investors.
3) Issuing shares abroad increases a company’s access to investors, increasing the amount of capital raised in share issues for a given expected rate of return for the estimated corporate risk.
In other words, companies look to international investors in order to raise more money at cheaper rates.
Companies usually start by sourcing capital from their domestic markets. From there, they often move to sourcing capital internationally by issuing foreign bonds, which work a lot like regular financial bonds.
If a company wants to issue equity internationally, the best method of attracting the attention of investors is usually to list equity on a foreign exchange. Doing so doesn’t issue new shares in the other country but allows people from that nation to purchase shares in secondary transactions (which can still raise capital for the company if it holds any treasury shares).
This process of having shares listed in more than one equity market is called cross-listing, and it allows foreign investors to purchase a company’s shares in a number of ways, including the following:
– Depository receipts: These receipts are traded like equity but are in fact representative of the equity held by another organization. They allow foreigners to invest without giving them direct foreign ownership.
– Global registered shares: These traditional shares of equity can be traded on multiple markets worldwide rather than a single equity market.
The decision to outsource (or transfer certain operations to an outside company) is a financial one that many companies have to deal with at some point. Basically, a company has to decide whether another company can perform one or more of its operations comparably and more cheaply than it currently performs them. The risks associated with outsourcing translate into potential costs, but as long as the amount the company saves by outsourcing the operation exceeds the expected costs associated with risk, outsourcing makes sense.
To decide whether outsourcing is right for your company, you can use a practice known as transfer pricing, in which each function of the company essentially ‘purchases’ and ‘sells’ to the other functions in the company.
Companies go to all this trouble — treating every function of their operations as independent customers and sellers to each other — because doing so allows them to determine whether they have competitive pricing in each of their functions.
As an example, imagine a motor-vehicle manufacturing plant in the US in which all the functions of building a car occur in the same plant. If, through transfer pricing, the US company discovers that an overseas firm is capable of selling cars with tires on them cheaper than the company can do itself (including the cost of shipping), that company may decide to outsource the tire-installation function. It ships the cars to the foreign firm to have the tires put on, and then that overseas company ships the cars with tires back to the US company for the next phase of production.
Transfer pricing is pretty standard in the form of accounting called activity-based costing, but many companies prefer to use other accounting methods and rely on this form of analysis only when considering outsourcing.
Although outsourcing sounds like a win-win situation, it often comes with additional costs. Here are a couple of them:
– In international finance, outsourcing any function overseas requires the transfer of assets over international boundaries. This can mean a company having to forgo assets, because sometimes outsourcing requires a company to export or import an item, or (in the case of customer service or accounting) to transfer funds to pay the other company. If the other company is providing goods or services to the end user, outsourcing may also require bringing funds back to the parent company.
– Outsourcing to another country involves taxation for companies and governments. Companies have to pay tariffs on goods they send to another country, and then they have to pay more tariffs on those goods when they receive them back again. These costs can add up very quickly, discouraging outsourcing and trade.
In order to ease the burden on companies some nations set up trade agreements that allow for reduced or eliminated taxation on the transition of goods across national borders. Others allow tax-free capital movement under certain circumstances.
For example, free-trade zones in China allow businesses to send goods to China, tax-free, for the purpose of altering those goods and then re-exporting them.
However, not all nations are as sensitive to the needs of businesses. Some nations even go so far as to limit or prohibit any money from leaving the country. In these cases, companies have to manage their capital movement carefully to make outsourcing work for them.
For instance, they can choose to acquire resources from within the foreign nation and send the resources back to their headquarters in their own country, allowing them to allocate their foreign earned income as costs instead of attempting to transfer the money itself at high tax rates or even illegally.