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Corporate Governance: An International Perspective


Globalisation has made cross-border investing more attractive and profitable but just as risky. The extent of this risk is highly dependent on the quality of corporate governance in the country where an international investor intends to do business. Corporate governance is defined as the organisational structure in the modern business system that provides the systems and mechanisms by which corporations can be administered and controlled in one direction towards the goals set by the state. A good corporate governance structure serves as the instrument to ensure that managers run business in the best interest of the corporate shareholders and stakeholders and that effective supervision is exercised over the management team so as to enable enterprises to create social wealth more effectively. Thus, corporate governance is crucial to the success or failure of an enterprise because it determines the control of financial market risks and the allocation of resources. In international business and finance, there are no hard-and-fast rules because different countries have different systems and traditions in interpreting and enforcing laws on corporate governance. Moreover, both tradition and legislation can change at any time to disrupt the business strategy of an investment firm. This paper then discusses the theories and principles in corporate governance as it affects international business, focusing on the modes by which these tenets are applied in actual practice and how investors devise their strategies and confront the attendant risks.

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Corporate Governance

The corporate governance system occupies the attention of an investor more than the concern on how developed is a country’s capital markets. How companies are guided into following the principles of corporate governance plays an increasing role in investment decisions (Morck & Steier, 2005). From the investors’ perspective, the quality of corporate governance appears to be as important as a company’s financial data, which sentiment became widespread in the aftershocks of recent corporate scandals like Enron, AOL and WorldCom. As a result, corporate governance has become the main concern of institutional investors when making their investment decisions (Solnik & Mcleavy, 2005). According to Stulz (2005), poor governance prevents investors from receiving a full return on their investment because third parties may pick off the yield before these get into the hand of the right party. In a poor governance setting, the value of firms is diminished in the capital markets such that the ability of entrepreneurs to raise enough money to finance their business activities is limited. This stymies the growth of companies and promotes smaller firms.

From an international perspective, there are two dimensions in corporate governance: the external country-level dimension and the internal firm-level dimension. The first dimension refers to the quality of a country’s laws and their enforcement, which determine to a large degree how investors will receive returns from their investment. Such returns are expected to be more meaningful if the laws efficiently protect the rights of investors in terms of coverage and enforcement (Copeland, et al., 2005). As for the internal firm-level dimension of corporate governance, it alludes to the options available to firms to make their companies well-governed. For example, they can band together as a group committed to a common policy of openness and disclosure so that corporate insiders would find it hard to take advantage of other investors (Elton, et al., 2003). In sum, the quality of corporate governance depends on the quality of external country-level and internal firm-level governance (Stulz, 2005).

According to Sercu (2008), corporate governance is conducive to investment if there are well-crafted laws and institutions that function adequately in terms of good auditing, financial health, shareholder protection, information disclosure and certification requirements. The challenge for international investors is that there are vast differences in the enforcement of such regulations and the legal environment across countries. In countries where governance is poor because of poor regulations and legal safeguards, the culprit is often official corruption. The higher the incidence of corruption, the higher concentration of corporate ownership in a few hands (Stulz, 2005). Under this condition, nothing can stop insiders from raiding the corporate coffers. When investors are thus poorly protected, the capital markets become weak and effectively prevented from performing their role of dispersing ownership and wealth. Good governance, in effect, means checks and balances to preclude misuse of funds as a result of the principal-agency theory. This corporate governance theory refers to the relationships between the firm owners (principal) and managers (agency), in which one determines the work and the other undertakes it (Klapper & Inessa, 2004). Governance is poor when there are no clear divisions between owners and managers because the two may work in cahoots to expropriate funds.

Global Finance & Business

In cross-border investment, it is mandatory for a company to first assess how corporate governance is influenced by a country’s legal system in terms of enforcing investment laws and protecting the rights of investors. These are the basic determinants of business performance and growth (Denis & McConnell, 2003). According to Ajami, et al. (2006), there are 10 specific areas related to corporate governance that may affect international investment:

  • Decision systems
  • Performance monitoring systems
  • Incentive-based compensation
  • Bankruptcy proceedings
  • Ownership structures
  • Creditor systems
  • Capital structures
  • Markets for corporate control
  • Markets for management services
  • Product market competition

Other inputs included in decisions to engage in global business and finance are a country’s international payments situation, international trade policy, level of economic development, including ethical and environmental issues (Charter & Tischner, 2001). Careful analysis is also required of a country’s international liquidity, banking and money supply, interest and inflation rates, exchange rates, international transactions, government accounts, gross domestic product and deflation rates (Bushman & Smith, 2001). For a Country Finance Officer (CFO), the specific concerns are the inter-relations between risk management, funding and valuation and the possible reneging on contract (Sercu, 2008). In one instance, a US-based investor went to court when a Scottish borrower failed to pay but the case dragged because the US and Scotland have two legal systems that contradicted each other.

Other than country managers, cross-border financial decisions are also made by heads of multinational corporations, portfolio managers, money managers, investment and commercial bankers, financial consultants/advisors and entrepreneurs. Amongst the more popular cross-border investment activities today are hedging, valuation and investing in emerging markets (Eun & Resnick (2006). To create and sustain firm value across borders, investors are encouraged to consider the four modules of international financial management:

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  1. Currencies and asset prices – decisions and strategies should work around the mechanics of exchange rates: how the rates are determined, how currencies influence stock prices, why and how central banks intervene in the foreign exchange markets.
  2. Multinational financial decision making – the investor must analyse the extent of a firm’s exposure to exchange rates, how it can hedge this exposure, how to capitalise subsidiaries, when to partner with local farms, and how tax considerations figure into its internal financial decision making.
  3. Cross-border valuation and financing – the firm should explore the ways by which valuation and financing decisions can be modified in cross-border settings to determine what amount of capital is enough in an emerging market and what kind of financing is appropriate when local laws are rigid.
  4. Institutions and finance – the firm examine how different laws and regulations can impact financial decisions, how entrepreneurial finance changes when property rights are uncertain, what to do in the face of possible expropriation, what roles do multilateral institutions play in the internal financial market, and how to mitigate such risks.

Principles & Theories

In principle, corporate governance is designed to 1) promote the equitable treatment and rights of stakeholders, 2) recognise the interests of other stakeholders, 3) define the roles and responsibilities of the board of directors, and 4) uphold the integrity and ethical behaviour of the company (Morck & Steier, 2005). These four goals of good governance are believed achievable when rules are set that provide for the separate positions of chairman and CEO, the appointment of outside CEO and directors to the board, and the composition of a smaller board of directors. On the separation of chairman and CEO, Denis & McConnell (2003) found no evidence that this induces good governance. What was found influential in improving firm performance is the appointment of an outsider as CEO, the dominance of outside directors in the board and a smaller composition of the board.

The modern theory of the firm and corporate governance holds that private ownership/control of corporations is better than government ownership/control. This reduces the political risks for cross-border investors and promotes the idea of privatization, which has been associated with greater productivity and higher growth. Based on a study of 79 privatised firms in 21 developing countries (Boubakri & Cossett, 1998 in Denis & McConnell, 2003), 218 Mexican companies (La Porta, et al.,.2002), and 6,354 firms in Eastern Europe (Claessens & Fan, 2002), privatisation of state-owned corporations added new life and vitality to previously stagnant companies. The implications are that it would be worthwhile for firms to consider the privatisation program in the countries where they want to invest.

Another important theory in international corporate governance is the Modern Portfolio Theory (MPT), which is also called portfolio management theory. It is a given that investors want higher returns but the little risk (Mattaroci, 2006). To avoid the inherent risks in cross-border finance, investors follow the MPT by attempting to sort out, estimate and control both the type and amount of expected risks and returns (Moorman, 2005). The essence of this theory is the quantification of the relationships between risk and return and the expectation that rewards await those that assume the risks (Eiteman, et al., 2006). This means that investors now analyze the statistical relationships among the items in an investment portfolio whilst previous examinations were limited to the characteristics of each investment. There are four basic steps involved in MPT:

  1. Security valuation – this describes the bundle of assets in terms of expected risks and returns.
  2. Asset allocation – this determines how the assets would be distributed among the different types of investment.
  3. Portfolio optimisation – this reconciles the risk and return by selecting the securities to be included in the investment portfolio based on which stocks promise the highest return for a given level of expected risk.
  4. Performance measurement – this divides the stocks according to performance and market-related or industry-related classifications ((Moorman, 2005).

The Modern Portfolio Theory looks at risk in this context as the standard deviation from the mean in each stock (Eiteman, et al., 2003). This means that in two high-risk assets, one will always yield a good return since a bundle of assets can reduce the overall risk. Thus, the theory lends credence to the homegrown advice to farmers not to put all their eggs in one basket. Under the MPT, the risk specific to one stock can be countered by diversification because such risk is reduced as the number of stocks in an investment portfolio is increased. For this reason, diversification is considered essential to the practice of portfolio management, together with the setting of a capital allocation line and an efficient frontier line. An investor engages in diversification if he holds a diversified portfolio of assets to minimise the risks posed by an individual asset. For this purpose, the investor secures instruments that are perfectly uncorrelated, avoiding those that are perfectly correlated or inversely correlated (La Porta, et al., 2002). As for the capital allocation line, it refers to the line of expected return drawn against the risk or standard deviation that connects all assets in the portfolio, while the efficient frontier line is the intersection between the set of portfolios with minimum variance and the set of portfolios with maximum return (Eiteman, et al., 2003).

In emerging markets, however, there are doubts about the efficiency of the Modern Portfolio Theory. Lins & Servaes (2002) studied 1,000 firms in seven emerging markets and found that diversified firms are less profitable than those focused on a single market segment. The primary reason is that newly industrialised economies have severe market imperfections and inefficient internal capital markets. The study also noted that diversification does not enhance the value of firms even in the developed economies of the US, UK, Japan and Germany. What happens is that the high cost of diversification in these developed countries offset the supposed benefits from the process. Nonetheless, Lins & Servaes (2002) believe that diversification may yet work for firms in emerging markets because they can mimic the beneficial functions of various institutions in developed markets that push that risk reduction activity.

Application & Practice

The study of Lins & Servaes (2002) showed that some investors used market imperfections to their advantage by forming themselves into an industry group. This group structure has allowed member firms to trade at a discount of almost 15 per cent because it enabled the expropriation by controlling shareholders of minority shareholders.

Next to diversification as a key MPT activity in risk reduction is hedging, which is the use of financial instruments to reduce or even eliminate the negative impact of an unstable exchange rate on the firm’s cash flow (Sercu, 2008). A prime instrument for hedging is the forward contract, which is also used in international financial management for the purposes of speculation, arbitrage, valuation and shopping around. Citibank applied this principle in practice when it sold a forward contract in Japanese yen to a local band for its planned nationwide tour. Before the event, however, the band dissolved but this did not affect Citibank, which then sold the contracted yen in the spot market. Under the forward contract, the bank had also specified that can revoke its own obligation for such a reason and so the net loss it suffered was smaller and could have even turned into again.

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On diversification as an MPT activity, the theory has been used by a firm called Quadriga Superfund, which now manages over $1.5 billion worth of futures funds for over 55,000 retail and institutional investors worldwide. The Superfund trades in 140 futures markets around the world through a proprietary trading system called TradeCenter. Quadriga is named after the four-horse chariot used by the soldiers and gladiators of ancient Rome. The metaphorical reference is meant to demonstrate the flexibility and all-around efficiency of Superfund, alluding to the way the Romans cleverly chose the four-horse complement such that a perceived weakness of one horse would be compensated by the power of the others. At Superfund, the four Quadriga horses are presented as symbols of the firm’s overall philosophy, which consists of diversification, technical excellence, money management and trend-following strategies. In its management of futures products, Superfund provides investments calculated to yield long-term capital growth, and a diversified global portfolio that guarantees more returns and less volatility. It steers away from traditional and more risky investments in stocks and bonds, where market correlations are nil. Because of the capability of TradeCenter to identify and respond to risks in split seconds, Superfund consistently produces double-digit returns on investment. This flexibility also springs from its highly diversified trades, which enable the firm to protect its investors even during market downturns. For the same reason, the firm changes the distribution of its managed funds from time to time when some sectors are being eroded by liquidity, volatility and other adverse market factors. Ordinarily, the Superfund investment pie is divided equally among trades in such commodity and financial futures as energy, metal, grains, agricultural markets, stock indices, currencies, bonds and the money market.

The above chart indicates the range of markets that Superfund trades or may trade, but the share of allocation for each investment area is changed from time to time depending on liquidity, volatility and risk considerations. This is in line with the Modern Portfolio Theory.


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