International Financial Management
Chapter 1 Features of international finance
Michael Connolly
School of Business Administration,
University of Miami
Michael Connolly © 2007
Chapter 1
International finance differs from finance in
several ways:
 Currencies
 Accounting rules
 Stake-holders
 Legal and institutional framework
 Language
 Taxation
 Regulatory framework
 Political risk
 Intellectual property rights
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Exchange rates
 Currency conversion
Spot rates – for “immediate” delivery
“On the spot”
Or within two business days
Futures and forwards –
Futures are standardized contracts traded
on exchanges, while
Forwards are over-the-counter tailored
contracts in terms of size, maturity and
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Exchange rates
 American quotations vs. European
American: USD per unit of foreign
Example: $1.7778 per GBP
European: Units of foreign currency
per USD
Example: 8.04 yuan (RMB) per USD
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Exchange rate risk
 Transaction exposure
Gains or losses due to unanticipated
changes in the exchange rate
associated with a foreign currency
Usually dealt with by offsetting
contractual hedges
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Exchange rate risk
 Operational exposure
Unanticipated changes in the value
of the cash flow from operations in
foreign exchange due to unexpected
changes in the exchange rate.
Usually dealt with by natural hedges
– matching cash flows.
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Exchange rate risk
 Translation exposure
 Accounting requirement: US Federal
Accounting Standards Board (FASB)
52 requires conversion of most line
items at the current exchange rate
to the USD for reporting of income
and financial statements.
Usually dealt with by matching cash
flows and accounting hedges.
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Accounting rules
In the United States
 Generally Accepted Accounting Practice
(GAAP) based on FASB rulings and law,
such as the SEC Act of 1934 and the
Sarbanes-Oxley Act of 2002
Internationally Accepted Standards (IAS)
based more on concept than rules and
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Accounting rules
 Reporting and disclosure requirements are
higher in the U.S., England, and
continental Europe than abroad:
specifically, in emerging markets
American Depositary Receipts (ADRs) are
frequently listed on US exchanges in lieu
of foreign shares due to disclosure and
reporting requirements
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In the US:
Shareholders are of utmost importance:
the objective of the firm is to maximize
shareholder wealth.
Often various stakeholders:
The Government is often a majority, state
owned enterprises (SOEs) or a minority
Management holds less shares than in the US
Workers and unions are often powerful and
have many legal rights
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Legal framework
Common laws in the US and the UK
Securities and Exchange Commission, 1934
US SEC Act of 1934 and SOX 2002
regulates securities offerings, disclosure and
US Foreign Corrupt Practices Act of 1997
(FCPA 1977) prohibits making payments to
foreign officials to obtain contracts, licenses
and favors
Civil penalties of up to $100,000 and
imprisonment for not more than 5 years, or
Exception for “grease money” - to expedite or
to secure the performance of a routine
governmental action by a foreign official, are
permitted unless prohibited by local laws
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Legal framework
Napoleonic laws
 France, Spain, Italy and most Latin
American countries are governed by the
Napoleonic Code. Louisiana is partially so
Islamic laws
 Interest prohibited by the Koran, but
profit sharing permitted
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Legal framework
In 1999, the Organization for Economic
Cooperation and Development (OECD) established A Convention Against Bribery of
Foreign Public Officials in International
Business which makes it a crime to offer,
promise or give a bribe to a foreign public
official in order to obtain or retain
international business deals
The UN Convention Against Corruption
(UNCAC) was signed by 113 countries since its
launching in December 2003
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Language can be either an obstacle or
an advantage.
Banco Santander Central Hispano of
Madrid - the largest bank in Latin
America in terms of assets - owes its
comparative advantage over other banks
in Latin America to language, Napoleonic
Law, and its long history of good banking
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Corporate income taxes
Statutory corporate income taxes vary:*
Countries such as Ireland are now tax havens for foreign direct
investment and foreign sales corporations, benefiting from a 10%
special tax rate, while others, such as Russia have adopted a flat tax
of 15% to encourage compliance.
*Source: Price Waterhouse.
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Corporate income tax
Corporate income tax collections are a small
percentage of GDP in general. However, the data
do not reflect marginal effective tax rates since
countries like Ireland with low effective tax rates
have greater compliance and attract FDI, thus
collecting a high percentage of GDP.
The US, on the other hand, has depreciation and
interest expenses as tax shields, so despite a high
marginal statutory rate, collections are low as a
percentage of GDP, as seen in the OECD countries
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Corporate income tax
T a x e s o n C o r p o r a t e I n c o m e in O E C D C o u n t r ie s in 2 0 0 2 a s a p e r c e n t a g e o f G D P
C o u n tr y
P e r c e n ta g e o f G D P
A u s tr ia
2 .3
Luxem bourg
A u s tr a lia
5 .3
M e x ic o
B e lg iu m
3 .5
N e th e r la n d s
3 .5
3 .3
N e w Z e a la n d
4 .2
C z e c h R e p u b lic
4 .6
N orw ay
8 .2
D enm ark
2 .9
P o la n d
2 .0
F in la n d
4 .3
P o r tu g a l
3 .6
2 .9
S lo v a k R e p u b lic
2 .7
G erm any
1 .0
S p a in
3 .2
G reece
3 .8
2 .4
H ungary
2 .4
S w itz e r la n d
2 .7
I c e la n d
1 .1
T urkey
2 .2
I r e la n d
3 .7
U n ite d K in g d o m
2 .9
I ta ly
3 .7
U n ite d S ta te s
1 .8
J apan
3 .2
U n w e ig h te d a v e r a g e
3 .4
R e p u b lic o f K o r e a
3 .1
W e ig h te d a v e r a g e
2 .5
S ource:
C o u n tr y
R e ve nu e S ta tistic s o f O E C D M e m b e r C o u ntrie s , T a b le 1 2 ,
* = d a ta n o t a va ila b le .
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P e r c e n ta g e o f G D P
8 .6
P a r is, O E C D , 2 0 0 4 .
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Capital gains taxation
Capital gains taxes vary and depend on the
length the investment is held. The US
reformed it’s rates in 2003, but these
expire in 2009, unless re-voted.
U nited S tates
S hort term rate
Long term rate
(less than one year)
(one year or longer)
> or = 25% regular incom e tax bracket (25, 33 or 35% )
< 25% regular incom e tax bracket (10 or 15% )
• A principal residence in the U.S. has a capital gains
exempt amount of US$250,000 (US$500,000 for
married persons filing jointly) for gains on the principal
residence if owned and occupied by the taxpayer as the
principal residence for greater than two years over prior
five years.
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Capital gains taxation
In the United Kingdom, capital gains are
taxed at top marginal personal rate on
savings income.
These are respectively:
10 per cent/20 per cent/40 per cent
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Transfer pricing
Transfer pricing involves the price one
branch of a company charges the other
for the transfer of intermediate goods
It can be used to transfer profits from a
high tax jurisdiction to a low tax jurisdiction
Foreign Sales Corporations (FSC)
 Under US laws, a FSC may incorporate
in a tax haven to promote exports. If
it does not repatriate profits, they go
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Transfer pricing
Under WTO regulations, a Foreign Sales
Corporation violates Article VI AntiDumping and Countervailing Duties since
U.S. corporations’ export earnings are
exempted from corporate taxes,
constituting an export subsidy.
Indeed, the European Union won its
anti-dumping case against the Foreign
Sales Corporation which is being phased
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The regulatory framework
The U.S. Securities and Exchange Commission
(SEC) regulates major exchanges and
securities dealers based on a simple concept:
all investors should have access to certain
basic facts about an investment prior to
buying it
The SEC requires public companies to disclose meaningful
information to the public to judge for themselves if a
company's securities are a good investment
SEC-governed typical infractions include insider trading,
accounting fraud, providing false or misleading information
about securities and issuing companies, and backdating of
options grants.
The SEC offers the public the EDGAR database of
required disclosure documents from public companies
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Political risk
Political risk: economic exposure to
unanticipated changes in governmental
policy that affect the earnings and value of
your affiliate or subsidiary, the most
serious being nationalization.
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Political risk
Political risk falls with WTO’s growing
The GATT/WTO’S Article III National Treatment on
Internal Taxation and Regulation requires equal
treatment for both domestic and foreign firms. Despite
national treatment requirements, discrimination against
foreign firms may still take place
Nationalization with a populist government coming to
 The foreign oil companies in Venezuela are facing
implicit nationalization through governmental decrees,
as was the case under Alan García in Perú from 198590 where they were explicitly nationalized
Possible solutions
 World Bank Multilateral Investment Guarantee
Association (MIGA) provides insurance against
investment risk in emerging markets
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Intellectual property rights
Pirated and counterfeit products are
commonplace worldwide
Software code, Madonna’s songs,
Microsoft’s latest Windows operating
system and its Office Suite, Rolex
watches, Lacoste shirts and so on
In some countries, the copying and
manufacture of patented
pharmaceuticals is perfectly legal
Brazil seems to be the greatest culprit
in Latin America.
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Intellectual property rights
Possible deterrents?
WTO member countries are to respect
international patents, trademarks and
brands (TRIPS –Trade related
intellectual property rights are to be
implemented according to the Uruguay
Round 1994)
As a WTO member, China is taking
steps to enforce intellectual
property rights
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International finance has an additional layer of
complication that involves currency risk and
conversion, different laws, regulations,
languages, and business practices
Today, however, world production and trade are
global in nature
Therefore, financing is also global
This leads to less market segmentation, more
liquidity, and greater efficiency in world
capital markets
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The Current Account and the Exchange Rate