UNIT 1

SCOPE OF INTERNATIONAL FINANCE -

Benefits: International business benefits both the nations and firms. Domestic business have
lesser benefits when compared to the former.

• To the nations: Through international business nations gain by way of earning foreign
exchange, more efficient use of domestic resources, greater prospects of growth and creation of
employment opportunities. Domestic business as it is conducted locally there would be no much
involvement of foreign currency. It can create employment opportunities too and the most
important part is business since carried locally and always dealt with local resources the
perfection in utilization of the same resources would obviously reap the benefits.

• To the firms: The advantages to the firms carrying business globally include prospects for
higher profits, greater utilization of production capacities, way out to intense competition in
domestic market and improved business vision. Profits in domestic trade are always lesser when
compared to the profits of the firms dealing transactions globally.

• Market Fluctuations: Firms conducting trade internationally can withstand these

situations and huge losses as their operations are wide spread. Though they face losses in
one area they may get profits in other areas, this provides for stabilizing during seasonal
market fluctuations. Firms carrying business locally have to face this situation which
results in low profits and in some cases losses too.
• Modes of entry: A firm desirous of entering into international business has several
options available to it. These range from exporting/importing to contract manufacturing
abroad, licensing and franchising, joint ventures and setting up wholly owned
subsidiaries abroad. Each entry mode has its own advantages and disadvantages which
the firm needs to take into account while deciding as to which mode of entry it should
prefer. Firms going for domestic trade does have the options but not too many as the
former one.To establish business internationally firms initially have to complete many
formalities which obviously is a tedious task. But to start a business locally the process is
always an easy task. It doesn't require to process any difficult formalities.
• Purvey: Providing goods and services as a business within a territory is much easier than
doing the same globally. Restrictions such as custom procedures do not bother domestic
entities but whereas globally operating firms need to follow complicated customs
procedures and trade barriers like tariff etc.
• Sharing of Technology: International business provides for sharing of the latest
technology that is innovated in various firms across the globe which in consequence will
improve the mode and quality of their production.
 • Political relations: International business obviously improve the political relations among
the nations which gives rise to Cross-national cooperation and agreements. Nations co-
operate more on transactional issues.

DOMESTIC VS INTERNATIONAL FINANCIAL MANAGEMENT (IFM)

Financial Systems may be classified as domestic or overseas, closed or open. A ‘domestic’ is one
inside a country. Thus financial system in the United States, is an international financial system
from the India’s view.

The means and objective of both domestic and international financial management remains the
same but the dimensions and dynamics broaden drastically.

Multiple Foreign currency

Market imperfections

Enhanced opportunity sets and

Political and legal risks

are four broader heads under which IFM can be differentiated from financial management. The
goal of IFM is not only limited to maximization of shareholders but also stakeholders.

However the following are the major differences between domestic and international financial
management-

• EXPOSURE TO FOREIGN EXCHANGE

The most significant difference is of foreign currency exposure. Currency exposure impacts
almost all the areas of an international business starting from your purchase from suppliers,
selling to customers, investing in plant and machinery, fund raising etc. Wherever you need
money, currency exposure will come into play and as we know it well that there is no business
transaction without money.

• MACRO BUSINESS ENVIRONMENT

An international business is exposed to altogether a different economic and political

environment. All trade policies are different in different countries. Financial manager has to
critically analyze the policies to make out the feasibility and profitability of their business
propositions. One country may have business friendly policies and other may not.

• LEGAL AND TAX ENVIRONMENT

The other important aspect to look at is the legal and tax front of a country. Tax impacts directly
to your product costs or net profits i.e. ‘the bottom line’ for which the whole story is written.
International finance manager will look at the taxation structure to find out whether the business
which is feasible in his home country is workable in the foreign country or not.

• THE DIFFERENT GROUP OF STAKEHOLDERS

It is not only the money which along matters, there are other things which carry greater
importance viz. the group of suppliers, customers, lenders, shareholders etc. Why these group of
people matter? It is because they carry altogether a different culture, a different set of values and
most importantly the language also may be different. When you are dealing with those
stakeholders, you have no clue about their likes and dislikes. A business is driven by these
stakeholders and keeping them happy is all you need.

• FOREIGN EXCHANGE DERIVATIVES

Since, it is inevitable to expose to the risk of foreign exchange in a multinational business.

Knowledge of forwards, futures, options and swaps is invariably required. A financial manager
has to be strong enough to calculate the cost impact of hedging the risk with the help of different
derivative instruments while taking any financial decisions.

• DIFFERENT STANDARDS OF REPORTING

If the business has a presence in say US and India, the books of accounts need to be maintained
in US GAAP and IGAAP.

It is not surprising to know that the booking of assets has a different treatment in one country
compared to other. Managing the reporting task is another big difference. The financial manager
or his team needs to be familiar with accounting standards of different countries.

• CAPITAL MANAGEMENT

In an MNC, the financial managers have ample options of raising the capital. A number of
options create more challenge with respect to the selection of the right source of capital to ensure
the lowest possible cost of capital.

IMPORTANCE -

Compared to national financial markets international markets have a different shape and
analytics. Proper management of international finances can help the organization in achieving
same efficiency and effectiveness in all markets, hence without IFM sustaining in the market can
be difficult.

Companies are motivated to invest capital in abroad for the following reasons
• Efficiently produce products in foreign markets than that domestically.

• Obtain the essential raw materials needed for production.

• Broaden markets and diversify

• Earn higher returns

• foreign investment

BALANCE OF PAYMENTS -

Balance Of Payment (BOP) is a statement which records all the monetary transactions made
between residents of a country and the rest of the world during any given period. This statement
includes all the transactions made by/to individuals, corporates and the government and helps in
monitoring the flow of funds to develop the economy.

When all the elements are correctly included in the BOP, it should sum up to zero in a perfect
scenario. This means the inflows and outflows of funds should balance out. However, this does
not ideally happen in most cases.

A BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e
when a country’s export is more than its import, its BOP is said to be in surplus. On the other
hand, the BOP deficit indicates that a country’s imports are more than its exports.

Tracking the transactions under BOP is something similar to the double entry system of
accounting. This means, all the transactions will have a debit entry and a corresponding credit
entry.

• Why is Balance of Payment (BOP) vital for a country?

A country’s BOP is vital for the following reasons:

1. The BOP of a country reveals its financial and economic status.

2. A BOP statement can be used as an indicator to determine whether the country’s currency
value is appreciating or depreciating.
3. The BOP statement helps the Government to decide on fiscal and trade policies.
4. It provides important information to analyze and understand the economic dealings of a
country with other countries.
 5. By studying its BOP statement and its components closely, one would be able to identify
trends that may be beneficial or harmful to the economy of the county and thus, then take
appropriate measures.

ELEMENTS OF A BALANCE OF PAYMENT

There are three components of balance of payment viz current account, capital account, and
financial account. The total of the current account must balance with the total of capital and
financial accounts in ideal situations.

Elements-of-balance-of-payment

Current Account

The current account is used to monitor the inflow and outflow of goods and services between
countries. This account covers all the receipts and payments made with respect to raw materials
and manufactured goods.

It also includes receipts from engineering, tourism, transportation, business services, stocks, and
royalties from patents and copyrights. When all the goods and services are combined, together
they make up to a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries. It could be
visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods
between countries are referred to as visible items and import/export of services (banking,
information technology etc) are referred to as invisible items.

Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries.
This can also be personal transfers like – money sent by relatives to their family located in
another country.

Capital Account

All capital transactions between the countries are monitored through the capital account. Capital
transactions include the purchase and sale of assets (non-financial) like land and properties.

The capital account also includes the flow of taxes, purchase and sale of fixed assets etc by
migrants moving out/into a different country. The deficit or surplus in the current account is
managed through the finance from the capital account and vice versa. There are 3 major elements
of a capital account:

Loans and borrowings – It includes all types of loans from both the private and public sectors
located in foreign countries.

Investments – These are funds invested in the corporate stocks by non-residents.

Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to
monitor and control the exchange rate does impact the capital account.

Financial Account

The flow of funds from and to foreign countries through various investments in real estates,
business ventures, foreign direct investments etc is monitored through the financial account. This
account measures the changes in the foreign ownership of domestic assets and domestic
ownership of foreign assets. On analyzing these changes, it can be understood if the country is
selling or acquiring more assets (like gold, stocks, equity etc).

Illustration

If for the year 2018 the value of exported goods from India is Rs. 80 lakh and the value of
imported items to India is 100 lakh, then India has a trade deficit of Rs. 20 lakh for the year
2018. The BOP statement acts as an economic indicator to identify the trade deficit or surplus
situation of a country. Analyzing and understanding the BOP of a country goes beyond just
deducting the outflows of funds from inflows. As mentioned above, there are various
components of BOP and fluctuations in these accounts which provide a clear indication about
which sector of the economy needs to be developed.

Unit 2

HISTORY AND EVOLUTION OF FOREIGN EXCHANGE MARKET -

Stage 1 – The Barter era

Before the advent of currencies, transactions occurred through something called the‘barter
system’. Barter system is a ‘method of exchange’ which has existed for many centuries. In a
typical barter, people exchange goods for other goods (or services). A classic example would be
– say a farmer has harvested cotton, he could exchange (or barter) cotton with another farmer
giving him wheat. Similarly a farmer who has oranges could exchange the oranges he has
harvested with someone who agrees to wash his cows and sheep.

The problem with the barter system was the scale and divisibility of the system. For example
assume a farmer had 5 bales of cotton and he wants to barter cotton with someone selling cattle,
assuming 2 bales for 1 cow, after the barter he’d be left with 2 cows and a bale of cotton. He
would certainly not get half a cow for 1 bale of cotton.

This caused a divisibility issue within the system.

The scalability was also an issue with the barter system – it required our farmer to travel from
one part of the country (with all his produce) to another part of the country to barter for goods of
his choice. Both these issues were eventually overcome with an improved system – Goods for
metal.

Stage 2 – Goods for Metal era

The problems that plagued the barter system eventually paved way to the next transaction
methodology. People tried to invent a common denominator for the ‘exchange’. The common
denominator ranged from food grains to metals. But eventually metals thrived for obvious
reasons. Metal was divisible, easily movable, and metal had no issue with shelf life. Further, of
all the metals, Gold and Silver were the most popular; therefore eventually these metals became
the standard for transactions.

The direct exchange between gold/silver and goods lasted for many centuries; however things
started to change when people deposited gold and silver coins in safe havens and issued a ‘paper’
against the value of gold. This paper derived its value based on the gold/silver coins deposited in
safe haven.

With time, safe havens evolved to banks and the paper transformed to different currencies.
Perhaps this was the start of the book entry of the currency system.

Stage 3 – The Gold Standard era

Over time, as domestic trade flourished, trading across borders also flourished. Economic sense
prevailed and merchants realized producing everything locally did not make sense. Merchants
started exploring cross border trade – simple import and export of goods thrived. This also meant
merchants transacting across border also required to pay for it in a currency that was acceptable
across borders. Banking systems also evolved, and somewhere around the late 19th Century
exchanging goods for Gold (not silver) became the norm. Valuing the local currency against the
value of gold was called the ‘Gold Standard’. As things progressed, geo political situation
changed (world wars, civil wars, cold wars etc) and so did the economic situation across the
world. When it came to cross border transactions, there was an urgent need for merchants to trust
one currency and value their own currency against that currency. This is when ‘Bretton Woods
System’ came to the picture. You can read more on the Bretton Woods System.

However, here is a simplified version of the Bretton Woods System (BWS). The BWS was a
way of defining the monetary relationship between countries, where the currencies were pegged
to USD at a fixed rate while the value of the USD itself was marked against the value of Gold.
Countries accepted this system with a room for 1% variation either side (against the pegged
value). Needless to say, with BWS in place the USD became the currency the world transacted
in, as USD was backed by Gold!

Developed countries slowly withdrew from the BWS system and eventually BWS became
history. Countries adopted a more market driven approach, where the market decided the value
of one currency against the other. The market drives the value of currencies based on the
political and economic landscape of a country versus the other. This brings us to where we are
now.

Foreign exchange market –

The foreign exchange market is a global online network where traders buy and sell currencies. It
has no physical location and operates 24 hours a day from 5 p.m. EST on Sunday until 4 p.m.
EST on Friday because currencies are in high demand. It sets the exchange rates for currencies
with floating rates.

Structure of foreign exchange market -

Participant # 1. Commercial Banks or Market Makers:

Commercial banks are normally taking over the position to support the economy of the country
by carrying over the foreign currency from one period to another, for meeting the future need of
the country. They are also sometime making short sale (agree to sell or actually sell the foreign
currency without any real capacity to sell through or borrow the required currency from others)
of foreign currency to satisfy the need of firms to make payments.

Later on to bring the position in equilibrium, they quote the rates for buying and selling of
foreign currency accordingly. As they are buying the foreign currency from the customer, the
rate they quote for buying the foreign currency is technically named as Bid rate. When they sell
the foreign currency to customer, the rate they quote is technically known as Ask rate.

Participant # 2. Foreign Exchange Brokers:

FE brokers do not buy or sell the foreign currency on their own account, as done by market
makers. They are working as an intermediary between two parties, to satisfy their respective
needs. As they are working as a bridge between buyers and sellers of the foreign currency, they
are only earning the fees in the form of brokerage charges.

Participant # 3. Central Banks or Reserve Bank of India:

To protect the financial strength and stability of the country’s balance of payments, internal
money supply, interest rates and inflation, RBI intervenes in the foreign exchange markets to
protect the disequilibrium in the prices of foreign exchange conversion.

Participant # 4. Corporates and Entrepreneurs:

Corporate are the players in the FE market, to satisfy their need of payment in foreign currency
towards imports of goods, commodities and services. On the opposite way, they need to convert
foreign currency in home currency on account of export of goods, commodities, and services.
The need of conversion also happens on account of transactions in financial markets across the
globe, for loan disbursement, repayment of loans, receipt and payment of annual charges, etc.

Types of transactions and settlement -

Spot quotation –

A transaction between two parties to exchange one currency for another at a rate which is agreed
upon today but whose settlement will take place in two business days.

For ex – If the contract is entered on 7th May, then settlement will take place on 9th May.

But if Ninth May is a holiday in either of the location then the settlement will roll to next
business day.

The currencies are represented as two way quotation and the following are the rules for interbank
dealing.

Two way quote RULES–

USD/INR SPOT 74.50/75.60

1. Each currency is denominated by three letter swift code ie INR, USD, CAD, AUD etc

2. The two currencies are separated by a hyphen or oblique.

3. The currency on our left is called Base currency and currency on our right is called
quoted currency.
4. The quote is in EUROPEAN TERMS OR AMERICAN TERMS or DIRECT QOUTE or
INDIRECT QUOTE.

5. In europen quote it is number units of currency per US DOLLAR EG – USD/INR = 75

WHICH is read as 75 rs per us dollar.

6. In American terms it is no. of units of USD per unit of foreign currency

Eg CHF/USD 0.8040

7. DIRECT QUOTE is number of units of the home country currency per unit of foreign
currency. In India, the direct quote will be USD/INR =75

8. INDIRECT QUOTE has number of unit of foreign currency per unit of home currency.

In India, indirect quote is INR/USD = 0.0133

9. TWO WAY QUOTE

10. SPOT QUOTATION AND TWO POINT ARBITRAGE

11. THREE POINT ARBITRAGE

12. PRACTICE QUESTION DONE IN CLASS