Theories of International Financial Management - Assignment Example

? Theories of International Financial Management (College) Theories of International Financial Management Introduction The concept and scope of financial management have undergone tremendous changes for the last few decades. However, still the fundamentals of this concept lie with the management of business finance to achieve the targeted financial objectives of business organizations. In the modern organizational settings, financial management focuses on wealth maximization, generation of cash reserves, and provision of adequate return on investment. Obviously, in the modern business environment, the idea of international financial management has considerable significance. With intent to increase cross-border trade for international expansion, nations have liberalized their cross-border trade regulations. Hence the world is said to have facilitated with effective circulation of ideas, languages and cultural ideologies. Countries opened their doors to each other and thereby entrepreneurs looked for opportunities even outside their home lands. This liberalization process was further intensified by the rapid advancement in telecommunication and transportation technologies which offered increased flexibility to day to day business operations. Apart from this, as described in the article International Financial Management (August 29, 2010), a series of financial innovations such as cross border stock listings, international mutual funds, currency derivatives, and multi currency bonds have also contributed to the development of international financial management. The practices and scope for domestic financial management and international financial management are entirely different. Although, the meaning and objective of financial management will not change in an international setting, its dimensions and ranges vary dramatically. This report will critically evaluate theories of international financial management and the extent to which each stands up in the real world. Major elements of financial management The management of business finance is a complex process as it plays a crucial role in each and every area of a business. For the successful operation of financial management process, three key elements have been included. They are financial planning, financial control, and financial decision making. 1. Financial planning As in the case of every management process, planning is an inevitable factor in the organizational financial management. It is necessary to ensure that sufficient fund is available at the right time in order to meet the business needs (The 100 times). An organization generally plans short term and long term financial programs. Short term funds are required to pay salaries to employees and to invest in stocks and other securities. On the other hand, medium and long term funds increase the productive capacity of the business for making business acquisitions. 2. Financial control Financial department is highly vulnerable to fraud. Hence every financial manager would implement ranges of internal check systems in order to check falsification of accounts and thereby fraudulent transactions of money. In short, the financial control element ensures the safety of business assets so as to comply with business rules and thereby act in accordance with the best interest of the shareholders. Financial decision making The important financial management decisions relate to investment, business financing, and distribution of dividends. It is the duty of the financial management to discover the most appropriate resource of money in times of contingencies. A most major financial management decision is whether the business profits must be retained as reserves or distributed to shareholders as dividend. This element is the focal point of the financial management process as this tool determines the degree of efficacy of business financing process. Domestic and international financial management These two concepts aim at the same goal but function differently to achieve them. To illustrate, four major factors such as foreign exchange, political risks, market imperfection, and enhanced opportunity cost notably distinguish international financial management from domestic financial management (International Financial Management, August 29, 2010). These factors are described below. 1. Foreign exchange It is a potential risk associated with international business transaction because a large fluctuation in global financial market would produce currency loss. Therefore, this risky element has the capacity to turn a profitable business deal into a loss making one. In contrast, this risk will not affect domestic financial management. 2. Political risks An international business organization will have business deals in several countries. The economic features such as taxation and other trade barriers of a country may be changed suddenly depending on government regulations. It would adversely affect the international financial management since this practice would seriously impinge on the financial forecasts. However, domestic financial management is less affected by this issue. 3. Market imperfection As Degennaro (2005) points out, different countries maintain different transport costs, taxation rates, and other costs; hence, financial managers would face a series of challenges while operating in an international business setting. In contrast, these issues do not affect domestic businesses. 4. Enhanced opportunity set When a firm operates in an international context, it explores and responds to numbers of opportunities. Probably, increased volumes of business deal include increased number of risk elements. In the case of domestic financial management, it faces comparatively smaller degree of risks. Theories of International Financial Management Although, notable differences are visible in the operations of international financial management, its common aim is to maximize shareholders’ wealth as it is in the case of domestic financial management. Increase in shareholders’ wealth directly indicates an increase in the price per share. It is obvious that all other goals of a business are subordinated to the welfare of shareholders. While dealing with share price maximization, it is essential to decide the currency in which the value of the share should be maximized. Since the international financial markets are totally different in their features, it is very difficult for multinational corporations to sustain in the market if they do not have expertise in international financial management. In order to bring similarity in international financial management practices, various theories have been formulated. Mundell-Fleming Model, the Purchasing Power Parity (PPP) theory, and Optimum Currency Area (OCA) theory are some of the most popular and controversial theories in international financial management (International finance). A. A. Mundell-Fleming Model The Mundell-Fleming Model was proposed by the Robert Mundell and Marcus Fleming, and it got a significant position in the field of international financial management. The merger of international monetary flows with macroeconomic analysis is considered to be the main cause of popularity of Mundell-Fleming Model (Mundell-Fleming Model). This model could forecast the significance of international capital flows in dealing with fundamental macroeconomic variables like unemployment, real national income, price level and interest rate. From Montiel’s (2009) point of view, the Mundell-Fleming Model is a wider extension of the Investment Saving/Liquidity preference Money supply (IS/LM) model (p.x). The key difference between IS-LM model and Mundell-Fleming Model is that the former mainly deals with a closed economy while the latter deeply describes an open economy. According to Chamberlin and Yueh (2006), Mundell-Fleming Model depicts the relationship between the nominal exchange rate and an economy’s output in the short run (p.431). In the words of Hung (2008), this model claims that it is impossible for an economy to maintain an independent monetary policy, free capital movement, and a fixed exchange rate simultaneously. This principle is commonly known as ‘Mundell-Fleming Trilemma’. The Mundell-Fleming Model is very useful to identify equilibrium income and its responses to economic shocks and policies. The model joins foreign exchange market (FE), the goods market (IS), and the money market (LM); this concept is much helpful to determine the interest rate and the exchange rate. This model sets forth three fundamental equations which are related to the IS curve, the LM curve and the balance of payments. Gamber and Colander (2006, p. 287) assert that Equalization of the local interest rate to the global interest rate is one of the important assumptions of Mundell-Fleming Model. Since this model relates to the nominal exchange rate, a change in exchange rate would produce considerable deviations in the applied curves. A flexible exchange rate regime emerges when the government allows the market forces to determine the exchange rates without the intervention of government. In contrast, the government announces the exchange rate under a fixed exchange rate regime. The trends of changes in money supply, government spending, and global interest rate largely fluctuate in accordance with the presence of a flexible or fixed exchange rate regime. Although, this model is an extension of the IS-LM model, it is observed that some of the outcomes obtained from Mundell-Fleming Model differ from that of IS-LM model. The feature of the open economy assumption of Mundell-Fleming Model can be attributed to this difference. Although, new open economy macroeconomics trends have developed in current research practices, none of them could surpass the effectiveness of the Mundell-Fleming Model. “The Mundell-Fleming Model still shines for its theoretical importance and empirical relevance, and retains its status as one of the workhorse models of international economics” (Huang , 2009). Since this model covers a wide range of features such as various degrees of capital mobility and diverse exchange rate regimes, it raises challenges to the newly proposed models. In short, Mundell-Fleming Model is a fundamental theory in international financial management which would greatly assist finance managers for ever. B. The purchasing power parity (PPP) As Taylor and Taylor (2004) points out, the idea behind the purchasing power parity theory was originated with the School of Salamanca in the 16th century. This theory was developed into its modern form by Gustav Cassel in 1918. The PPP theory works on the basis of relative price levels of two countries and it reveals the ideas related to long term equilibrium exchange rates. When a country’s inflation rate rises, its exports proportionally decline due to higher prices. This situation would in turn leads to a decline in country’s currency demand. At the same time, consumers and organizations in that country may tend to engage in importing activities intensively. In the view of Madura (2008, p.214), both forces of declined exports and increased imports would put a downward pressure in country’s currency. Countries’ inflation rates vary from time to time on the ground of their monetary policy practices. The PPP theory “attempts to quantify inflation-exchange rate relationship” (Madura, 2008). The author also adds that the purchasing parity theory has two popular forms such as absolute form of PPP and relative form of PPP, each of which raises its own implications. The absolute form of PPP functions on the strength of the concept that consumers switch their demand to different places on the ground of price changes and without considering international barriers. This theory suggests that the same products’ prices in two different countries must be equal when it is measured in a common currency. In the words of Madura (2008), any deviation from this concept would reflect the convergence of these prices or difference in the purchasing power for the same products across countries. The existence of tariffs, transportation costs, and other related expenses limit the scope of absolute form of PPP. In the case of relative form of PPP theory, it states that the same products’ prices in two different countries may not necessarily be the same when it is measures in a common currency because of the market imperfections like transportations costs and tariffs. It is identified that the international dollar is the best purchasing power adjustment by which the real exchange rate equals to the nominal exchange rate. However, the exchange rate reflects short run and long run divergences from this price because of various reasons. In real practice, it is very difficult to find similar basket of goods for the purpose of comparison and thereby to evaluate purchasing power across difference countries; hence, the PPP exchange rate calculation is a cumbersome task. The purchasing power parity theory or PPP theory is one of the potential theories in international financial management. Even in the modern days, this theory is widely used to compare the cost of living between two countries on the ground of purchasing power. As it is a simplest theory to compare the purchasing power between two countries, even non- experts can practice this theory. However, presently some economists argue that the goods chosen in the comparison index would largely influence the PPP exchange rate calculation. C. Optimum currency area (OCA) The optimum currency area (OCA) or optimal currency region (OCR) represents a geographical region which vehemently tries to improve its economic efficiency with intent to have the entire region share a single currency. This theory has been developed and later expanded by the combined contributions of Mundell, McKinnon, and Kenen. “OCA theory, with its focus on asymmetric shocks, labor mobility, and the transactions value of a single currency, subsumes but a subset of considerations relevant to the decision of whether to fix the exchange rate or form of a monetary union” (Eichengreen, 1997, p.111). However, it is very difficult to transform this concept from the theoretical framework to real practice or empirical work. However, this theory tries to describe the necessary characteristics for the integration of different currencies for the creation of a new single currency. When a region is ready to transform into a monetary region, it indicates one of the most significant final phases in the process of economic integration. It is evident that the optimum currency area cannot be often restricted to the boundary limits of a country although it could be smaller than a country in terms of theoretical perspectives. The creation of euro for the whole Europe assists it to represent an optimum currency area. Frankel and Rose (1998) argue that there are four main criteria that are necessary for the successful operation of a currency union. It seems that the concept of optimum currency area is more frequently practiced by European Union. McKinnon (1963) claims, the openness of the economy must be more focused while dealing with this concept. From the above part, it is clear that the optimum currency area is a complex concept which is difficult to comprehend and apply. Moreover, ranges of other effective theories have been developed which would replace the applications of the optimum currency area concept. Therefore, it seems that the concept of optimum currency area has not much significance in the modern international financial management. In other words, the practicability of this theory greatly depends on ranges of measures and assumptions; and hence, financial mangers today hardly take up this concept. Conclusion The international finance theories play a vital role in coordinating diverse financial practices effectively. The Mundell-Fleming Model, an extension of the IS-LM model could successfully forecast the significance of international capital flows in order to identify various crucial macroeconomic variables. Similarly, the purchasing power parity is a fruitful concept to explore and compare the cost of living between two countries on the ground of purchasing power. These two theories successfully produce potential outcomes even in modern days. Although ranges of other theories have been initiated to replace these two models, it still exists as fundamental models in international finance. The optimum currency area model proposes to have the entire region share a single currency. However, it is not widely used in the modern international financial management as includes comparatively complex ideas and procedures. References Chamberlin, G & Yueh, L. (2006). Macroeconomics. US: Thomson. Hung, P. (2008). “Impossible Trinity, Capital flow market and financial stability”. Hong Kong Baptist University. Retrieved from http://www.apeaweb.org/confer/bei08/papers/mo_p.pdf Degennaro, R. P. (2005). “Market imperfections”. Working paper series. Federal Reserve Bank of Atlanta. Retrieved from http://www.frbatlanta.org/filelegacydocs/wp0512.pdf Eichengreen, B. J. (1997). European monetary unification; Theory, practice, and analysis. US: MIT Press. Frankel, J. A and Rose, A. K. (1998). “The endogenity of the optimum currency area criteria”. The Economic Journal, 108, (449), 1009-1025. Financial planning. The 100 times. Retrieved from http://www.thetimes100.co.uk/theory/theory--financial-planning--300.php Gamber, E & Colander, D. C. (2006). Macroeconomics. South Africa: Prentice Hall. Huang, L. (2009). “A Logical inference and extension of the Mundell-Fleming model”. School of Economics. The Peking University, Beijing. Retrieved from http://ssrn.com/abstract=1530608 International Financial Management. (August 29, 2010). E-finance Management. Retrieved from http://efinancemanagement.com/international-financial-management/74-international-financial-management International finance. Retrieved from http://wn.com/international_finance Mundell-Fleming Model. The works of Robert Mundell. Retrieved from http://robertmundell.net/mundell-as-in/mundell-fleming-model/ Madura, J. (2008). International financial management. Edition 9, US: Cengage Learning. McKinnon, R. I. (1963). “Optimum currency areas”. The American Economic Review, 53, (4), 717-725. Montiel, P. J. (2009). International macroeconomics. MA, US: John Wiley & Sons. Taylor, A. M & Taylor, M. P. (2004). The purchasing power parity debate. The National Bureau of Economic Research. retrieved fromhttp://www.nber.org/papers/w10607 Read More