Knowledge of international finance can help a financial manager decide how international events will affect a firm and what steps can be taken to exploit positive developments and insulate the firm from harmful ones. Among the events that affect the firm and that must be managed are changes in exchange rates as well as interest rates, inflation rates, and asset values. These different changes are themselves related. For example, declining exchange rates tend to be associated with relativelyhigh interest rates and inflation. Furthermore, some asset prices are positively affected by a declining currency, such as stock prices of export-oriented companies that are more profitable after devaluation.
Other asset prices are negatively affected, such as stock prices of companies with foreign-currency denominated debt that lose when the company’s home currency declines: the company’s debt is increased in terms of domestic currency. These connections between exchange rates, asset and liability values, and so on mean that foreign exchange is not simply a risk that is added to other business risks. Instead, the amount of risk depends crucially on the way exchange rates and other financial prices are connected. For example, effects on investors when exchange rates change depend on whether asset values measured in foreign currency move in the same direction as the exchange rate, thereby reinforcing each other, or in opposite directions, thereby offsetting each other. Only by studying international finance can a manager understand matters such as these. International finance is not just finance with an extra cause of uncertainty. It is a legitimate subject of its own, with its own risks and ways of managing them.
There are other reasons to study international finance beyond learning about how exchange rates affect asset prices, profits, and other types of effects described earlier. Because of the integration of financial markets, events in distant lands, whether they involve changes in the prices of oil and gold, election results, the outbreak of war, or the establishment of peace, have effects that instantly reverberate around the Earth. The consequences of events in the stock markets and interest rates of one country immediately show up around the globe, which has become an increasingly integrated and interdependent financial environment. The links between money and capital markets have become so close as to make it futile to concentrate on any individual part.
In this book we are concerned with the problems faced by any firm whose performance is affected by the international environment. Our analysis is relevant to more than the giant multinational corporations (MNCs) that have received so much attention in the media. It is just as valid for a company with a domestic focus that happens to export a little of its output or to buy inputs from abroad. Indeed, even companies that operate only domestically but compete with firms producing abroad and selling in their local market are affected by international developments. For example, US clothing or appliance manufacturers with no overseas sales will find US sales and profit margins affected by exchange rates which influence the dollar prices of imported clothing and appliances.
Similarly, bond investors holding their own government’s bonds, denominated in their own currency, and spending all their money at home, are affected by changes in exchange rates if exchange rates prompt changes in interest rates. Specifically, if governments increase interest rates to defend their currencies when their currencies fall in value on the foreign exchange markets, holders of domestic bonds will find their assets falling in value along with their currencies: bond prices fall when interest rates increase. It is difficult to think of any firm or individual that is not affected in some way or other by the international financial environment.
Jobs, bond and stock prices, food prices, government revenues, and other important financial variables are all tied to exchange rates and other developments in the increasingly global financial
environment.