Abstract

Internalization theory is a recognition of market imperfections that prevent efficient international trade and investment. It shows that the multinational enterprise (MNE) has developed in response to government regulations that negate the theoretical rationale for free trade and private foreign investment as explanations of international trade and investment. The article assumes that the international capital market is not perfectly integrated, in contrast to the domestic capital markets of the United States and other major industrialized nations, which are assumed to be perfect, but the degree of capital market imperfection is unimportant because the general principle of internalization of markets comes into force once segmentation of the international capital market is recognized. Given that the unique risk facing the MNE is foreign exchange risk, the first apparent application of the theory of internalization would be to hedging, speculation, and arbitrage. The article investigates some of the other major areas of corporate international finance, international diversification, transfer pricing, and the financial structure of the MNE, including its cost of capital and finance function.