Modern Financial Markets - Term Paper Example

Table of Contents Table of Contents 1 Introduction 2 Benefits of international diversification 2 Complexities associated with international diversification 5 Costs arising from international diversification 6 Conclusion 8 Reference 10 Bibliography 12 Introduction The advanced and sophisticated modern financial markets provide the opportunity for international diversification. With the integration of the worldwide markets the investors are now in a position to seek higher returns and lower the risk level of their investment. The research conducted in the area of international portfolios concentrates primarily on the various methods of reduction of foreign exchange risks. The process of international diversification enables the firms to reap in advantages like economies of scale. According to Bartlett & Ghoshal (2000) it accelerates the process of innovation besides reducing the associated costs. However there is no consistency in the empirical studies with regard to the performance advantages arising from international diversification. Various studies conducted by Buckley & Casson (1976), Caves (1982) and Rugman (1979) have drawn attention to the internationalisation theory, highlighting that the process of international diversification does not improve performance rather the leveraging of the intangible assets of the firm bring in performance advantages. This calls for advanced ways of information co-ordination and processing in order to identify and take advantage of the overseas opportunities. As per Kogut (1985b) the acquisition of this form of information co-ordination and processing requires significant investments and the gains arising from the international diversification varies across the firms (Chari et al., 2007). Benefits of international diversification An international business initiative can lower the overall risk of firm owing to the benefits associated with international diversification (Madura, 2008, p.375). It enables the firms to make more returns on their innovation by way of accessing a number of markets and brings down the risks associated with research and development investments. Therefore, it can be inferred that international diversification provides the necessary incentives for innovative practices (Hitt et al., 2007, p.232). This form of diversification enhances the market potential of the various product lines of the firms but this also gives rise to the complexities of managing a firm that is internationally diversified as well as product diversified. Research has shown that the gains from geographic and product diversification are higher in the case of media firms. It has also been seen that in the less developed economies the firms benefit more from product diversification as compared to the businesses in developed economies. The international diversification offers exploitation and exploration benefits. As per Caves (1996) by way of internationalisation the firms can achieve economies of scope and scale. Kim et al (1993) highlight that the fluctuations in the revenues of the firm can be can be reduced by distributing the investment risks across various countries. The international operations facilitate cost reduction and enhance revenue base as it strengthens the market position of the firm giving it a strong bargaining power over the customers, suppliers and distributors. The firm may have unutilised resources therefore by way of international expansion the firm is able to achieve economies of scale. A higher production lowers the overall production costs (Lu & Beamish, 2004). Evidences have shown that top management groups that are culturally diverse are more informed about the international markets and their unconventional behaviour. The impetus for internationalisation arises from the availability of the opportunities of exploiting market imperfections from the use of intangible assets across the border. According to Buckley (1988) a business can achieve extra-normal returns by using its internal assets mainly the intangible assets in the international arena. In recent times the scholars have highlighted the exploration benefits arising from internationalisation from the perspective of organisational learning. As per Barkema et al the above view point that the subsidiaries of the firm in disparate nations enables enhancement of knowledge, competitiveness and capabilities through various experiential learning. Other than this every host country is endowed with unique resources and locational advantages that may not be there in the domestic country. These advantages motivate a business to set up subsidiaries in the host country in order to boost its competitiveness both in the host and the domestic market. It is argued that promotion of information co-ordination and processing capability an investment in IT enables the firms to identify and exploit the available opportunities from the use of internal assets and thereby raise the performance from geographical diversification. The identification of the global opportunities requires the firm managers to have a broad view of the market. According to Kogut (1985b) and Prahalad & Doz (1987) it has been observed that the organisation based on global products or based on geography results in administrative efficiency as its allows the firm to have a clearly demarcated lines of responsibility and authority. Internationalisation theory states that the multinational corporations (MNCs) face some disadvantages with respect to their operations in a foreign country like it may not be accustomed with the indigenous culture. To tackle this MNC must possess some internal assets that provide them an edge over the firms in the host country. Therefore the assets that give rise to diversification benefits from internationalisation include expertise in marketing and R&D facilities and a superior knowledge of other activities. Morck & Yeung (1991) suggest that from the perspective of internationalisation theory a firm can take advantage of the firm-specific or internal assets across the international markets for enhancing the performance from global diversification (Lu & Beamish, 2004). The leveraging decisions do not merely arise from knowledge about the available opportunities as these decisions also require a trade-off between the local responsiveness and international efficiency along with the managers’ level of commitment. For instance the decision of developing a product of global nature by making use of the expertise spread across various countries requires the efforts of various units of these multiple countries. The various country units differ in terms of resource endowments. Other than this the various country units also differ with regard to the benefits derived from a project on account of varying levels of national responsiveness prevailing across various markets. Complexities associated with international diversification Though a number of benefits can be derived by pursuing an international strategy but the process of international diversification is complex as well as uncertain. The off-shore projects mainly the ones in the developing markets are considered to be risky (Lessard, n.d.). Like cross-country operations give rise to multiple risks. Often the large and diversified firms become unmanageable or their managing costs outweigh the benefits. At times the managers have to face complexities in the institutional and cultural systems. An example of this complexity is evident in the operation of Toyota. In a bid to raise sales the automobile company became increasingly focused on the North American market thereby giving rise to quality issues and deteriorating customer satisfaction. Other complex issues include competitive nature of the international markets, varying cultural environments, unexpected shifts in the value of foreign currency and the stability issues of the host country (Hitt et al., 2007, p.232). Any form of political instability in the host country can hamper the off-shore companies engaged in the indigenous operations. Like a change in the government can have serious implications for the foreign companies operating in the region. It is possible that the new government is averse to liberalisation. This can affect the operations of the overseas companies doing business in the region. Any change in the legal policy can also disrupt the operations of an MNC doing business in the region. If the legal framework is tightened so as to enforce restrictions on repatriation of funds then the company may lose control over its precious assets. Costs arising from international diversification As per Hymer (1976) and Stinchcombe (1965) the costs associated with international diversification include foreignness and problems like “liabilities of newness”. When a foreign investment is initiated the manager of the firm has to face a number of challenges with respect to the new set-up like acquisition and installation of facilities, staffing and establishment of internal control systems as well as external business environment. The presence of an already established business in the market of the host country can deter a newly formed subsidiary. Faced by the challenges the subsidiary may lose its competitiveness. In the absence of a skilled man-power in the host market the firm may face issue relating to staffing. Either it will have to train the workers or it has to bring in new workers from outside. External challenges may arise if there is already a strong player in the target market. It is often difficult to penetrate the market with dominant industry players. A newly formed subsidiary of an MNC may face difficulty in penetrating this market. According to Barkema et al (1996) state that the above liabilities diminish with time as the subsidiary of the firm is able to establish its legitimacy and build a reputation in the target market of the host country (Lu & Beamish, 2004). The challenges are said to be the pack and parcel of setting up a subsidiary however there are some difficulties that are specific to establishing a subsidiary in a foreign country. The “liability of foreignness” faced by a foreign subsidiary can create additional costs as the firm may not be in a position to conduct activities as efficiently as an indigenous firm. A foreign origin increases the chances of mistakes in making business decisions. However, the mistakes and the associated costs can be attenuated with time and by gradual learning. With the passage of time the limitations of foreignness is reduced as the firm can adapt to the local know-how and cultural practices. John & Hill (1988) state that though the disadvantages arising from newness diminish as the firm gains experience in the target market there is a rise in the coordination and transaction costs with the geographical diversification. As per Williamson (1975) the literature on diversification contains arguments in favour of transaction costs and provides evidence in support of the costs ensuing from product diversification. Like Williamson (1967) state that passing of information across the various chains of hierarchy leads to distortion of information (Lu & Beamish, 2004). Most of the costs arising from product diversification are valid in the case of international diversification also. As per Denis et al (2002) information asymmetry, co-ordination related difficulties and misalignment of incentives between the divisional managers and headquarters is manifest in the case of MNCs between the subsidiary managers and headquarters. With the increase in internal transactions due to a rise in foreign subsidiaries the governance costs also move up. As per Hitt et al (1997) after a point the governance costs cross the internalisation benefits. Every country possesses a distinct business environment. Bartlett & Ghoshal (1989:87) the co-ordination of operations across the various countries results in diseconomies in the management of large operations. This creates increased demand for information processing on the administrative system of the firm. Moreover expansion in the dissimilar markets raises environmental uncertainty which further burdens the costs associated with hierarchical governance. Conclusion From the above analysis it can be concluded that one must be careful in associating any immediate outcome with an international diversification strategy. The link between firm performance and internationalisation varies as per the internationalisation phase. The research conducted in this field must give equal weight age to the benefits as well as the costs ensuing from the process of internationalisation in both the initial and later stages of the process. Empirical findings highlight that there exists a dynamic relationship between firm performance and international diversification. In this respect the heterogeneity of the firm like the firm-specific advantages and other business structures and decisions influence the performance of an international diversification. Moreover the significance of the intangible assets in the process of internationalisation cannot be underestimated. An interesting reality about internationalisation is that in the recent years the reputation of a firm precedes entry in a foreign market. There have been instances when the managers of firms investing internationally have witnessed that their firm’s reputation i.e. their superior intangible assets such as brands and patents have already reached before the actual foray into the market. Reference Chari, R.D.M. Devaraj, S. David, P. 2007. International diversification and firm performance: Role of information technology investments. Journal of World Business 42 (2007) 184–197. Available at: http://auapps.american.edu/~parthiba/jwb.pdf [Accessed on March 11, 2011]. Hitt, A.M. Ireland, D.R. Hoskisson, E.R. 2007. Strategic management: competitiveness and globalization : concepts & cases. Cengage Learning. Lessard, R.D. No Date. Incorporating Country Risk In The Valuation of Offshore Projects. Massachusetts Institute of Technology. Available at: http://dlessard.scripts.mit.edu/docs/Lessard,%20Incorporating%20Country%20Risk....pdf [Accessed on March 11, 2011]. Lu, W.J. Beamish, W.P. 2004. INTERNATIONAL DIVERSIFICATION AND FIRM PERFORMANCE: THE S-CURVE HYPOTHESIS. Academy of Management Journal 2004, Vol. 47, No. 4, 598–609. Available at: http://www.im.uni-jena.de/wiwimmedia/Dokumente/Lehre/Seminar%2BWS%2B2010_11/Empirischer%2Bwissenschaftlicher%2BArtikel.pdf [Accessed on March 11, 2011]. Madura, J. 2008. International Financial Management. Cengage Learning. Bibliography Baxter, M. Jermann, J.U. 1997. The International Diversification Puzzle Is Worse Than You Think. The American Economic Review, Vol.87, No.1. Available at: http://www.stanford.edu/~thrhee/BaxterJermann_InternationalDiversification.pdf Bull, H. 1966. International Theory: The Case for a Classical Approach. World Politics, Vol. 18, No. 3 (Apr., 1966), pp. 361-377. Available at: http://tigger.uic.edu/~bvaler/bull.pdf Griffin, M.J. Karolyi, A.G. 1998. Another look at the role of the industrial structure of markets for international diversification strategies. Journal of Financial Economics 50 (1998) 351Ð373. Available at: http://www.jgriffin.info/Research/Diversification.pdf Heathcote, J. Perri, F. 2008. The international diversification puzzle is not as bad as you think. Available at: http://www9.georgetown.edu/faculty/jhh9/homebias.pdf Rowland, F.P. Tesar, L.L. 1998. Multinationals and the Gains from International Diversification. Available at: http://fordschool.umich.edu/rsie/workingpapers/Papers401-425/r425.pdf Read More