Direct foreign investment (DFI) occurs when a business or a person claims at least a ten percent ownership of a foreign corporation. Although this percentage does not give a controlling interest to the investor, it permits the influence over the firm’s operations, policies, and management (Erdilek 17). Subsequently, unlike a short-term debt, a long-term debt takes more than a year to mature. Entities issue long-term debt by primarily concentrating on the interest to be paid and the repayment timeframe. On the other side, investors choose this type of debt based on the payback of interest payments. Moreover, the international equity market involves the issuing and trading of shares, either through over-the-counter or exchanges market (Konvisarova and Levchenko 167). This financial market gives investors a portion of company ownership and provides firms with access to capital and a possibility of deriving gains depending on its performance in the future. Based on the understanding of the three types of investment, this paper focuses on the reasons for DFI and immunization of a balance sheet after the creation of a foreign asset. In addition, it discusses the advantages of using either euro-bonds or foreign bonds.
Companies and investors may opt for DFI due to eight key reasons. First, the wage rate is among the key factors that influence FDI. A multinational company will prefer to invest in countries that have lower wage rates, especially when manufacturing products that are labor-intensive (Erdilek 25). For instance, if America’s average wages are $10 per hour compared to India’s $2 an hour, production costs can be minimized by outsourcing cheap labor (Erdilek 30). Second, some sectors such as electronics and pharmaceuticals require a highly educated and skilled labor force. As a result, investors will choose those countries that demonstrate a combination of high labor skills and productivity, and low wages (Erdilek 36). Third, international companies may choose to invest in nations with lower business tax rates. For instance, Ireland has successfully attracted investment from Microsoft and Google (Erdilek 48). Fourth, FDI is driven by the presence of reliable infrastructure and transport in the host country. While some countries may have a low cost of labor, investors may face other significant drawbacks such as poor infrastructure and high transport expenses to deliver the products to the global market.
The fifth reason for DFI is related to population size and the potential for economic growth. For instance, the large populace in China and the country’s emerging middle class can create a strong demand for products of multinational corporations (Erdilek 58). Sixth, economic and political stability plays a critical role in attracting DFI. Typically, most economic crises originate from unstable political environments. For instance, the recent economic crisis in Russia can be a key deterrent to DFI (Erdilek 62). Moreover, political certainty is reflected in a country’s law and order, trust in reputable institutions such as the judiciary, and corruption level. Seventh, access to raw materials has been one of the motives behind DFI. For example, most Chinese firms have highly invested in African countries to capitalize on the high availability of unexploited raw materials (Erdilek 72). Eighth, foreign investors tend to be attracted by a country’s weak foreign exchange rate as it becomes cheaper to buy assets. Thus, the eight reasons represent the major factors that contribute to FDI.
After creating a foreign asset, there are numerous reasons for immunizing the balance sheet. Essentially, immunization is a risk-mitigation approach that aims to match the duration of liabilities and assets, reducing the risk of changes in multiperiod interest rates (Xidonas et al. 595). This strategy helps large institutions and firms shield their portfolios from vulnerability to future movements in interest rates by balancing a long-term liability with the foreign asset in the same currency and amount. Typically, pure immunization means that a firm invests in a portfolio for a known return in a specific duration irrespective of any external influence (Xidonas et al. 596). For example, the creation of a zero-coupon bond should be matched with the bond’s maturity and the exact date that the cash flow is anticipated (Xidonas et al. 600). This approach alleviates any positive or negative unpredictability of return that is connected to cash flow reinvestment. Thus, immunization safeguards a portfolio against changes in interest rates.
A dedicated immunization strategy becomes more relevant when an entity or an investor needs to finance a future obligation. If well-executed, this technique can offer huge gains to investors (Xidonas et al. 601). For instance, if an investor or business intends to hold a foreign bond for three years to fund a future obligation, they will have to immunize the balance sheet (Xidonas et al. 602). After one year and nine months, the investment horizon should be one and a half years. The investor will have to rebalance the duration of the portfolio to correspond to one and a half years. However, immunization is associated with such challenges as difficulties in timing and calculating future liabilities. Moreover, this approach depends on the assumption that changes in interest rates reflect fluctuations in all forms of bond maturities by a similar amount. This correlation rarely occurs in the real world, making duration matching even more problematic (Xidonas et al. 604). Immunization is required to set the portfolio’s duration equal to the time horizon of the investor and ensure that the bond’s present value is equivalent to the liability’s current value.
Foreign bonds and Eurobonds represent the two main bonds of international markets. By definition, a bond is a long-term obligation that is issued by governments and corporations (Konvisarova and Levchenko 167). Proceeds realized from bonds are used to mobilize funds to support long-term projects. The bond issuer pledges to pay a certain amount in the future upon its maturity, accompanied by coupon interest on the borrowed money. A foreign bond entails a long-term bond issued outside the issuing country and is usually denominated in the currency of the nation to which they are issued (Konvisarova and Levchenko 167). On the other, a Eurobond is also a long-term bond that is issued and traded outside the country of the currency which they are denominated (Konvisarova and Levchenko 168). For instance, a U.S. dollar-denominated bond in Britain or South Africa. Typically, Eurobond provides an avenue through which a country can borrow as a single entity. Thus, bond markets facilitate the transfer of funds from government units and companies with excess money to similar bodies that require long-term funds.
Eurobonds and foreign bonds are beneficial to both issuers and investors. These bond markets are advantageous to the borrowers as there is flexibility and freedom that is not available in domestic markets (Konvisarova and Levchenko 168). In addition, the borrowers enjoy Eurobond as it offers them an opportunity to develop a robust institutional framework for the placing, distribution, and underwriting of securities. Furthermore, Eurobond helps the issuers to avoid forex risk or currency risk (Konvisarova and Levchenko 169). Similarly, investors derive benefits from foreign bonds and Eurobonds in four major ways. First, these bonds enable them to diversify their investment portfolio, which creates a sense of security by reducing potential risks associated with political and economic instability (Konvisarova and Levchenko 169). Second, investors can hedge against a falling or weak local currency. Third, international market bonds have a smaller face value, are highly liquid, and are relatively cheaper than domestic bonds (Konvisarova and Levchenko 169). Finally, bonds issued outside the investors’ country and in bearer form are not subject to domestic income tax. Thus, both the borrowers and investors benefit from foreign bonds and Eurobonds.
In summary, there are several motivations behind DFI and balance sheet immunization, especially after the introduction of a foreign asset. Characteristically DFI is influenced by eight major reasons, including low wage rates, highly skilled and educated labor force, lower corporate tax rate, reliable transport, and infrastructure. Moreover, multinationals may opt for DFI due to such factors as large population and huge potential for economic development, economic and political stability, access to raw materials, and weak foreign exchange rates. In addition, the major reason for the immunization of a balance sheet is to protect the investment portfolio against fluctuations in multiperiod interest rates. Furthermore, immunization is used whenever an investor wants to use a foreign asset to fund a future liability. This strategy aims to ensure that portfolio returns are certain with a specific duration regardless of external influences. Additionally, foreign bonds and Eurobonds are the two key bonds of international market. These bonds offer numerous benefits to both investors and issuers. For instance, Eurobond is among one of the safest ways through which the borrowers can evade currency risk. Likewise, these two bonds help investors in their portfolio diversification.
Works Cited
Erdilek, Asim. Multinationals as Mutual Invaders: Intra-Industry Direct Foreign Investment. Routledge, 2018.
Konvisarova, Elena, and Tatiana Levchenko. “Attracting of Foreign Investments for National Economy Through the Emission of Eurobonds.” Russian Journal of Agricultural and Socio-Economic Sciences, vol. 72, no. 12, 2017, pp. 167–170, 10.18551/rjoas.2017-12.22.
Xidonas, P., et al. “An Integrated Matching-Immunization Model for Bond Portfolio Optimization.” Computational Economics, vol. 51, no. 3, 2016, pp. 595–605.