Why Study International Finance?

Why study the subject of international money and finance? One reason is that career goals are paramount to many people, and in this regard the topic of the text is related to a growth area in the labor market. This book provides a background in international finance for those who expect to obtain jobs created by international investment, international banking, and multinational business activity. Other readers may have a more scholarly concern with “rounding out” their economic education by studying the international relationships between financial markets and institutions. Although a course in principles of economics is the only prerequisite assumed for this text, many students may have already taken intermediate macroeconomics, money and banking, or essentials of finance courses. But for those interested in international economic relationships, such courses often lack a global orientation. The economic models and discussions of the typical money and banking course focus on the closed economy, closed in the sense that the interrelationships with the rest of the world are ignored. Here we study the institutions and analysis of an integrated world financial community, thus giving a better understanding of the world in which we live. We will learn that there are constraints as well as opportunities facing the business firm, government, and the individual investor that become apparent only in a worldwide setting.

Finance and the Multinational Firm

A multinational firm is a firm with operations that extend beyond its domestic national borders. Such firms have become increasingly sophisticated in international financial dealings because international business poses risk and return opportunities that are not present in purely domestic business operations. A US multinational firm may have accounts payable and receivable that are denominated in US dollars, Japanese yen, British pounds, Mexican pesos, Canadian dollars, and euros. The financial managers of this firm face a different set of problems than the managers of a firm doing business strictly in dollars. It may be true that “a dollar is a dollar,” but the dollar value of yen, euros, or pesos can and does change over time. As the dollar value of the yen changes, the value of yen-denominated contracts will change when evaluated in terms of dollars.

Multinational finance responds to this new set of challenges with a tool kit of techniques and market instruments that are used to maximize the return on the firm’s investment, subject to an acceptable level of risk. Once we extend beyond the domestic economy, a rich variety of business opportunities exist that must be utilized with the appropriate financial arrangements. This book intends to cover many aspects of these international financial transactions that the financial manager may encounter. The financial side of international business differs from the study of international trade commonly encountered in international economics courses. Courses in international trade study the determinants of the pattern and volume of world trade—formally referred to as the theory of comparative advantage. If country A produces and exports shoes in exchange for country B’s food, we say that A has a comparative advantage in shoes and B has a comparative advantage in food. Besides comparative advantage, such courses also examine the movement of factors of production, labor, and capital goods between nations. Obviously, these subjects are important and deserve careful study, but our purpose is to study the monetary consequences of such trade. Although we will not explicitly consider any theories of comparative advantage—such theories are usually developed without referring to the use of money—we will often consider the impact of monetary events on trade in real goods and services. Our discussions range from the effects of the currency used in pricing international trade (Chapter 12) to financing trade in the offshore banking industry (Chapter 5). We will find that monetary events can have real consequences for the volume and pattern of international trade.

The Actors

This course is not simply a study of abstract theories concerning the international consequences of changes in money supply or demand, prices, interest rates, or exchange rates. We also discuss the role and importance of the institutional and individual participants. Most people tend to think immediately of large commercial banks as holding the starring role in the international monetary scene. Because the foreign exchange market is a market where huge sums of national currencies are bought and sold through commercial banks, any text on international finance will include many examples and instances in which such banks play a major part. In fact, Chapter 1 begins with a discussion of the role of banks in the foreign exchange market.

Besides commercial banks, other business firms play a key part in our discussion, since the goods and services they buy and sell internationally effect a need for financing such trade. The corporate treasurer of any multinational firm is well versed in foreign exchange trading and hedging and international investment opportunities. What is hedging? How are international investment opportunities related to domestic opportunities? These are subjects we address in Chapters 4 and 6. Finally, we examine the role of government. Central banks, such as the Federal Reserve in the United States, are often important actors in our story. Besides their roles of buying, selling, lending, and borrowing internationally, they also act to restrict the freedom of the other actors. The policies of central governments and central banks are crucial to understanding the actual operation of the international monetary system, and each chapter will address the impact of government on the topic being described.

Plan of Attack

This book can be thought of in terms of four main sections. To aid our understanding of the relationships among prices, exchange rates, and interest rates, we will consider existing theories, as well as the current state of research that illuminates their validity. For those students who choose to proceed professionally in the field of international finance, the study of this text should provide both a good reference and a springboard to more advanced work—and ultimately employment. Chapters 1, The Foreign Exchange Market, Chapter 2, International Monetary Arrangements, Chapter 3, The Balance of Payments identify the key institutions and the historical types international monetary system as well as discussing the current system. In Chapters 4, Forward-Looking Market Instruments, Chapter 5, The Eurocurrency Market, Chapter 6, Exchange Rates, Interest Rates, and Interest Parity; Chapter 7, Prices and Exchange Rates, the international monetary system is expanded by allowing payments to be due in a future time period. This results in a need for hedging instruments and expands the interaction between financial variables in different countries.

Chapter 8, Foreign Exchange Risk and Forecasting; Chapter 9, Financial Management of the Multinational Firm; Chapter 10, International Portfolio Investment; Chapter 11, International Portfolio Investment, are devoted to applied topics of interest to the international financial manager. Issues range from the “nuts and bolts” of financing imports and exports to the evaluation of risk in international lending to sovereign governments. The topics covered in these chapters are of practical interest to corporate treasurers and international bankers.

Chapter 12, Determinants of the Balance of Trade, Chapter 13; The IS-LM-BP Approach; Chapter 14, The Monetary Approach; Chapter 15, Extensions to the Monetary Approach of Exchange Rate Determination, cover the determinants of balance of payments and exchange rates. Government and industry devote many resources to trying to forecast the balance of payments and exchange rates. The discussion in these chapters includes the most important recent developments. Although there is some disagreement among economists regarding the relative significance of competing theories, as far as possible in an intermediate-level presentation, the theories are evaluated in light of research evidence. Altogether, these chapters present a detailed summary of the current state of knowledge regarding the determinants of the balance of payments and exchange rates.

At the beginning of this introduction we asked: Why study international money and finance? We hope that the brief preview provided here will have motivated you to answer this question. International finance is not a dull “ivory tower” subject to be tolerated, or avoided if possible. Instead, it is a subject that involves dynamic real-world events. Since the material covered in this book is emphasized daily in the newspapers and other media, you will soon find that the pages in International Money and Finance seem to come to life. To this end, a daily reading of The Wall Street Journal or the London Financial Times makes an excellent supplement for the text material. As you progress through the book, international financial news will become more and more meaningful and useful. For the many users of this text who do not go on to a career in international finance, the major lasting benefit of the lessons contained here will be the ability to understand the international financial news intelligently and effectively.