When a firm operates only in the domestic market, both for procuring inputs as well as selling its output, it needs to deal only in the domestic currency. As companies try to increase their international presence, either by undertaking international trade or by establishing operations in foreign countries, they start dealing with people and firms in various nations. Since different countries have different domestic currencies, the question arises as to which currency should the trade be settled in. The settlement currency may either be the domestic currency of one of the parties to the trade, or may be an internationally accepted currency. This gives rise to the problem of dealing with a number of currencies. The mechanism by which the exchange rate between these currencies (i.e., the value of one currency in terms of another) is determined, along with the level and the variability of the exchange rates can have a profound effect on the sales, costs and profits of a firm. Globalization of the financial markets also results in increased opportunities and risks on account of the possibility of overseas borrowing and investments by the firm. Again, the exchange rates have a great impact on the various financial decisions and their movements can alter the profitability of these decisions.
In this increasingly globalize scenario, companies need to be globally competitive in order to survive. Knowledge and understanding of different countries’ economies and their markets is a must for establishing oneself as a global player. Studying international finance helps a finance manager to understand the complexities of the various economies. It can help him understand as to how the various events taking place the world over are going to affect the operations of his firm. It also helps him to identify and exploit opportunities, while preventing the harmful effects of international events. A thorough understanding of international finance will also assist the finance manager in anticipating international events and analyzing their possible effects on his firm. He would thus get a chance to maximize profits from opportunities and minimize losses from events which are likely to affect his firm’s operations adversely.
Companies having international operations are not the only ones, which need to be aware of the complexities of international finance. Even companies operating domestically need to understand the issues involved. Though they may be operating domestically, some of their inputs (raw materials, machinery, technological know-how, capital, etc.) may be imported from other countries, thus exposing them to the risks involved in dealing with foreign currencies. Even if they do not source anything from outside their own country, they may have foreign companies competing with them in the domestic market. In order to understand their competitors’ strengths and weaknesses, awareness and understanding of international events again gains importance.
What about the companies operating only in the domestic markets, using only domestically available inputs and neither having, nor expecting to have any foreign competitors in the foreseeable future? Do they need to understand international finance? The answer is in the affirmative. Globalization and deregulation have resulted in the various markets becoming interlinked. Any event occurring in, say Japan, is likely to affect not only the Japanese stock markets, but also the stock markets and money markets the world over. For e.g., the forex and money markets in India have become totally interlinked now. As market players try to profit from the arbitrage opportunities arising in these markets, the events affecting one market also end up affecting the other market indirectly. Thus, in case of occurrence of an event which has a direct effect on the forex markets only, the above mentioned domestic firm would also feel its indirect effects through the money markets. The same holds good for international events, thus, the need for studying international finance.
Globalization essentially involves the various markets getting integrated across geographical boundaries. Integration of financial markets involves the freedom and opportunity to raise funds from and to invest anywhere in the world, through any type of instrument. Though the degree of freedom differs from country to country, the trend is towards having a reducing control over these markets. As a result of this freedom, anything affecting the financial markets in one part of the world automatically and quickly affects the rest of the world also. This is what we may call the Transmission Effect. Higher the integration, greater is the transmission effect.
Financial markets were not always as integrated as they are today. A number of factors are behind this change. The most important reason is the remarkable development of technology for transfer of money and information, making the same possible at an extremely fast speed and at considerably reduced cost. This has made possible the co-ordination of activities in various centers, even across national boundaries. Another significant development was the sudden increase in the inflation levels of various industrial countries which resulted in the price of various financial assets changing widely in response to the changes in the domestic inflation rates and the interest rates in different countries. These developments led to some others, which contributed all the more to the process of globalization. They are:
- The development of new financial instruments: For example, instruments of the euro-dollar market, interest rate swap, currency swap, futures contracts, forward contracts, options, etc.
- Liberalization of regulations governing the financial markets: Though the extent and direction of liberalization has been different in different countries, based on the domestic compulsions and the local perspective, it has been substantial enough to make operations in foreign markets a lucrative affair.
- Increased cross penetration of foreign ownership: This has helped in the countries developing an international perspective while deciding on various factors influencing the process of globalization.
The function of the financial system is to efficiently transfer resources from the surplus units to the deficit units. Greater integration of the financial markets helps in performing this function in a better manner. Just like natural resources are distributed unequally among various countries, some countries are capital-rich, while others are capital-poor. Capital-rich countries generally enjoy a lower return on capital than the capital-poor countries. Let us imagine the scenario where there is no capital flows between these two sets of countries. In the absence of adequate capital, the capital-poor countries will have to either forego or postpone some of the high-yielding investments. On the other hand, capital-rich countries will be investing in some of the low-yielding investments due to lack of better opportunities. When capital flows are allowed to take place, investors from the capital-rich countries would invest in the high-yielding projects available in the capital-poor countries. This would benefit both the countries. The residents of the capital-rich country will benefit by earning a higher return on their investments, and the cash-poor country will benefit by earning profits on the project, which they would otherwise have had to forego. Integration of financial markets thus results in a more efficient allocation of capital and a better working financial system.