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nternational Financial Management is a well known term in todays world and it is also known as

international finance. It means financial management in an international business environment. It is

different because of different currency of different countries, dissimilar political situations, imperfect
markets, diversified opportunity sets.

International Financial Management
International Financial Management came into being when the countries of the world started
opening their doors for each other. This phenomenon is well known with the name of
liberalization. Due to the open environment and freedom to conduct business in any corner
of the world, entrepreneurs started looking for opportunities even outside their country-
boundaries. The spark of liberalization was further aired by swift progression in
telecommunications and transportation technologies that too with increased accessibility and
daily dropping prices. Apart from everything else, we cannot forget the contribution of
financial innovations such as currency derivatives; cross border stock listings, multi-currency
bonds and international mutual funds.
The resultant of liberalization and technology advancement is todays dynamic international business
Financial management for a domestic business and an international business is as dramatically
different as the opportunities in the two. The meaning and objective of financial management does not
change in international financial management but the dimensions and dynamics changes drastically.
Difference between International and Domestic Financial Management:
Four major facets which differentiate international financial management from domestic financial
management are introduction of foreign currency, political risk and market imperfections and
enhanced opportunity set.
Foreign Exchange: Its an additional risk which a finance manager is required to cater to under an
International Financial Management setting. Foreign exchange risk refers to the risk of fluctuating
prices of currency which has the potential to convert a profitable deal into a loss making one.
Political Risks: Political risk may include any change in the economic environment of the country viz.
Taxation Rules, Contract Act etc. It is pertaining to the government of a country which can anytime
change the rules of the game in an unexpected manner.
Market Imperfection: Having done a lot of integration in the world economy, it has got a lot of
differences across the countries in terms of transportation cost, different tax rates, etc. Imperfect
markets force a finance manager to strive for best opportunities across the countries.
Enhanced Opportunity Set: By doing business in other than native countries, a business expands
its chances of reaping fruits of different taste. Not only does it enhances the opportunity for the
business but also diversifies the overall risk of a business.
Just like domestic financial management, the goal of International Finance is also to maximize the
shareholders wealth. The goal is not only is limited to the Shareholders but extends to all
Stakeholders viz. employees, suppliers, customers etc. No goal can be achieved without achieving
welfare of shareholders. In other words, maximizing shareholders wealth would mean maximizing the
price of the share. Here again comes a question, whether in which currency should the value of the
share be maximized? This is an important decision to be taken by the management of the
International level initiatives like General Agreement on Trade and Tariffs (GATT), The North
American Free Trade Agreement (NAFTA), World Trade Organization (WHO) etc has give promoted
international trade and given it a shape. All because of liberalization and those international
agreements, we have a buzz word called MNC i.e. Multinational Corporations. MNCs enjoy an edge
over other normal companies because of its international setting and best opportunities.
International Finance has become an important wing for all big MNCs. Without the expertise in
International Financial Management, it can be difficult to sustain in the market because international
financial markets have a total different shape and analytics compared to the domestic financial
markets. A sound management of international finances can help an organization achieve same
efficiency and effectiveness in all markets

Forex Market Participants
Consumers and Travelers
Consumers may purchase goods in a foreign country or via the internet with their credit card.
The amount consumers pay in the foreign currency will be converted to their home currency
on their credit card statement.
Travelers must go to a bank or currency exchange bureau to convert one currency (their
"home" currency) into another (the "destination" currency) when using cash to pay for goods
and services in a foreign country.
Travelers need to be aware of exchange rates to ensure they receive a fair deal.
Businesses often need to convert currencies when they conduct trade outside their home
Large companies need to convert huge amounts of currency; a multinational company such
as General Electric (GE) for instance, converts tens of billions of dollars each year.
Investors and Speculators
Investors and speculators require currency exchange whenever they deal in any foreign
investment, be it equities, bonds, bank deposits, or real estate.
Investors and speculators also trade currencies in an attempt to benefit from movements in
the currency exchange markets.
Commercial and Investment Banks
Commercial and investment banks trade currencies as a service to their commercial banking,
deposit, and lending customers.
These institutions also participate in the currency market for hedging and speculative
Governments and Central Banks
Governments and central banks trade currencies to improve economic conditions or to
intervene in an attempt to adjust economic or financial imbalances.
Because they are non-profit, governments and central banks do not trade with the intention
of earning a profit, but because they tend to trade on a long-term basis, it is not unusual for
some trades to earn revenue.

Forex Market
The Forex market is an international over-the-counter market (OTC). It means that it is a
decentralized, self-regulated market with no central exchange or clearing house, unlike stocks and
futures markets. This structure eliminates fees for exchange and clearing, thereby reducing
transaction costs.
The Forex OTC market is formed by different participants with varying needs and interests that
trade directly with each other. These participants can be divided in two groups: the interbank market
and the retail market.
The Interbank Market
The interbank market designates Forex transactions that occur between central banks, commercial
banks and financial institutions.
Central Banks - National central banks (such as the US Fed and the ECB) play an important role in
the Forex market. As principal monetary authority, their role consists in achieving price stability and
economic growth. To do so, they regulate the entire money supply in the economy by setting interest
rates and reserve requirements. They also manage the country's foreign exchange reserves that they
can use in order to influence market conditions and exchange rates.
Commercial Banks - Commercial banks (such as Deutsche Bank and Barclays) provide liquidity to
the Forex market due to the trading volume they handle every day. Some of this trading represents
foreign currency conversions on behalf of customers' needs while some is carried out by the banks'
proprietary trading desk for speculative purpose.
Financial Institutions - Financial institutions such as money managers, investment funds, pension
funds and brokerage companies trade foreign currencies as part of their obligations to seek the best
investment opportunities for their clients. For example, a manager of an international equity portfolio
will have to engage in currency trading in order to buy and sell foreign stocks.
The Retail Market
The retail market designates transactions made by smaller speculators and investors. These
transactions are executed through Forex brokers who act as a mediator between the retail market
and the interbank market. The participants of the retail market are hedge funds, corporations and
Hedge Funds - Hedge funds are private investment funds that speculate in various assets classes
using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design
and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting a
country and its currency. Due to their large amounts of liquidity and their aggressive strategies, they
are a major contributor to the dynamic of Forex Market.
Corporations - They represent the companies that are engaged in import/export activities with
foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in
exchange for goods, exposing them to currency risks. Through the Forex market, they convert
currencies and hedge themselves against future fluctuations.
Individuals - Individual traders or investors trade Forex on their own capital in order to profit from
speculation on future exchange rates. They mainly operate through Forex platforms that offer tight
spreads, immediate execution and highly leveraged margin accounts.

Q.1 : Define Foreign Exchange and Explain the Functions of Foreign
Exchange Market. (M.2011)
Foreign Exchange refers to foreign currencies possessed by a country for
making payments to other countries. It may be defined as exchange of money or credit in
one country for money or credit in another. It covers methods of payment, rules and
regulations of payment and the institutions facilitating such payments.
A foreign exchange market refers to buying foreign currencies with domestic
currencies and selling foreign currencies for domestic currencies. Thus it is a market in
which the claims to foreign moneys are bought and sold for domestic currency. Exporters
sell foreign currencies for domestic currencies and importers buy foreign currencies with
domestic currencies.
According to Ellsworth, "A Foreign Exchange Market comprises of all those
institutions and individuals who buy and sell foreign exchange which may be defined as
foreign money or any liquid claim on foreign money". Foreign Exchange transactions result
in inflow & outflow of foreign exchange.
Foreign exchange is also referred to as forex market. Participants are
importers, exporters, tourists and investors, traders and speculators, commercial banks,
brokers and central banks.
Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are
the important foreign exchange instruments used in foreign exchange market to carry out its
The Foreign Exchange Market performs the following functions.
1. Transfer Of Purchasing Power I Clearing Function
The basic function of the foreign exchange market is to facilitate the conversion
of one currency into another i.e. payment between exporters and importers. For eg. Indian
rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety
of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills.
Telegraphic transfer is the quickest method of transferring the purchasing power.
2. Credit Function
The foreign exchange market also provides credit to both national and
international, to promote foreign trade. It is necessary as sometimes, the international
payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are
used in international payments, a credit for about 3 months, till their maturity, is required.
For eg. Mr. A can get his bill discounted with a foreign exchange bank in New
York and this bank will transfer the bill to its correspondent in India for collection of money
from Mr. B after the stipulated time.
3. Hedging Function
A third function of foreign exchange market is to hedge foreign exchange risks. By
hedging, we mean covering of a foreign exchange risk arising out of the changes in
exchange rates. Under this function the foreign exchange market tries to protect the interest
of the persons dealing in the market from any unforseen changes in exchange rate. The
exchange rates under free market can go up and down, this can either bring gains or losses
to concerned parties. Hedging guards the interest of both exporters as well as importers,
against any changes in exchange rate.
Hedging can be done either by means of a spot exchange market or a forward
exchange market involving a forward contract.

Q. 2 : Explain the dealers or participants in foreign exchange market. (M.2011)
Foreign exchange market needs dealers to facilitate foreign exchange
transactions. Bulk of foreign exchange transaction are dealt by Commercial banks &
financial institutions. RBI has also allowed private authorised dealers to deal with foreign
exchange transactions i.e buying & selling foreign currency. The main participants in foreign
exchange markets are
1. Retail Clients
Retail Clients deal through commercial banks and authorised agents. They
comprise people, international investors, multinational corporations and others who need
foreign exchange.
2. Commercial Banks
Commercial banks carry out buy and sell orders from their retail clients and of
their own account. They deal with other commercial banks and also through foreign
exchange brokers.
3. Foreign Exchange Brokers
Each foreign exchange market centre has some authorised brokers. Brokers
act as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer

4. Central Banks
Under floating exchange rate central bank does not interfere in exchange
market. Since 1973, most of the central banks intervened to buy and sell their currencies to
influence the rate at which currencies are traded.
From the above sources demand and supply generate which in turn helps to
determine the foreign exchange rate.
Foreign Exchange Market is of two types retail and wholesale market.
1. Retail Market
The retail market is a secondary price maker. Here travellers, tourists and
people who are in need of foreign exchange for permitted small transactions, exchange one
currency for another.
2. Wholesale Market
The wholesale market is also called interbank market. The size of transactions in this
market is very large. Dealers are highly professionals and are primary price makers. The
main participants are Commercial banks, Business corporations and Central banks.
Multinational banks are mainly responsible for determining exchange rate.
3. Other Participants
a) Brokers
Brokers have more information and better knowledge of market. They provide
information to banks about the prices at which there are buyers and sellers of a pair of
currencies. They act as middlemen between the price makers.
b) Price Takers
Price takers are those who buy foreign exchange which they require and sell
what they earn at the price determined by primary price makers.

c) Indian Foreign Exchange Market
It is made up of three tiers
i. Here dealings take place between RBI and Authorised dealers (ADs) (mainly
commercial banks).
ii. Here dealings take place between ADs
iii. Here ADs deal with their corporate customers.
Q. 3 : Define I Explain I Write note on spot and forward exchange rates.
Transactions in exchange market are carried out at what are termed as
exchange rates. In foreign exchange market two types of exchange rate operations take
place. They are spot exchange rate and forward exchange rate.
1) Spot Exchange Rate :-
When foreign exchange is bought and sold for immediate delivery, it is called
spot exchange. It refers to a day or two in which two currencies are involved. The basic
principle of spot exchange rate is that it can be analysed like any other price with the help of
demand and supply forces.
The exchange rate of dollar is determined by intersection of demand for and
supply of dollars in foreign exchange. The Remand for dollar is derived from countrys
demand for imports which are paid in dollars and supply is derived from countrys exports
which are sold in dollars.
The exchange rate determined by market forces would change as these forces
change in market. The primary price makers buy (Bid) or sell (ask) the currencies in the
market and the rates continuously change in a free market depending on demand and
supply. The primary dealer (bank) quotes two-way rates i.e., buy and sell rate.
(Bid) Buy Rate 1 US $ = ` 45.50
(Ask) Sell Rate 1 US $ = ` 45.75
The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The
difference of Rs.0.25 is the profit margin of dealer.
2) Forward Exchange Rate
Here foreign exchange is bought or sold for future delivery i.e., for the period of
30, 60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market
deals in contract for future delivery. The price for such transactions is fixed at the time of
contract, it is called a forward rate.
Forward exchange rate differs from spot exchange rate as the former may
either be at a premium or discount. If the forward rate is above the present spot rate, the
foreign exchange rate is said to be at a premium. If the forward rate is below the present
spot rate, the foreign exchange rate is said to be at a discount. Thus foreign exchange rate
may be at forward premium or at forward discount.
For Eg. an Indian importer may enter into an agreement to purchase US $
10,000 sixty days from today at 1 US $ = Rs. 48. No amount is paid at the time of
agreement, except for usual security margin money of about 10% of the total amount. 60
days form today, the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective
of the Spot exchange rate prevailing on that date.
a) Factors Influencing Forward Exchange Rate
i) Interest rates.
ii) Degree of speculation in foreign exchange market.
iii) Inflation rate.
iv) Foreign investors confidence in domestic country.
v) Economic situation in the country.
vi) Political situation in the country.
vii) Balance of payments position etc.
b) Need For Forward Exchange Rate Contracts
To overcome the possible risk of loss due to fluctuations in exchange rate,
exporters, importers and investors in other countries may enter in forward exchange rate
In floating or flexible exchange rate system the possibility of wide fluctuation in
exchange is more. Thus, both exporters and importers safeguard their position through a
forward arrangement. By entering into such an arrangement both parties minimize their loss.

Q. 4 : Write note on Arbitrage. O R
Write note on Interest rate and Arbitrage.
Arbitrage is the act of simultaneously buying a currency in one market
and selling it in another to make a profit by taking advantage of exchange rate differences in
two markets. If the arbitrages are confined to two markets only it is said two-point
arbitrage. If they extend to three or more markets they are known as three-point or multi-
point arbitrage. Those who deal with arbitrage are called arbitrageurs.
A Spot sale of a currency when combined with a forward repurchase in a single
transaction is called Currency Swap". The Swap rate is the difference between spot and
forward exchange rates in currency swap.
Arbitrage opportunities may exist in a foreign exchange market.. Suppose the
rate of exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then
an arbitrageur can buy dollars in US market and sell it in Indian market and get a profit of `. 5
per dollar..
In todays modern well connected and advanced markets, arbitrageurs (which
are mainly banks) can spot it quickly and exploit the opportunity. Such opportunities vanish
over a period of time and equilibrium is again maintained.
For Eg.
Bank A ` / $ = 50.50 / 50.55
Bank B ` / $ = 50.40 / 50.45
The above rates are very close. The arbitrageur may take advantage and he can
purchase $ 1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50,
thus making a profit of 0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit
is earned without any risk and blocking of capital.
Interest arbitrage refers to differences in interest rates in domestic market and
in overseas markets. If interest rates are higher in overseas market than in domestic market,
an investor may invest in overseas market to take the advantage of interest differential.
Interest arbitrage may be covered and uncovered.
1) Uncovered Arbitrage
In this system, arbitrageurs would take a risk to earn profit by investing in a
high interest bearing risk free securities in a foreign market. His earnings would be according
to his calculations if the currency of foreign market where he invested does not depreciate. If
depreciation is equal to the difference in interest rate, the investor would not incur loss.
However, if depreciation is more than interest rate, then the arbitrageur will incur loss.
For Eg. In New York interest rate on 6 month Treasury Bill is 6% and in Spain it
is 8%. An US investor may convert US dollars in EURO and invest in Spain, thereby taking
an advantage of +2% interest rate. Now when bill matures, US investor will convert EURO
into dollars. However, by that time EURO may have depreciated the US investor will get less
dollars per EURO. If EURO depreciates by 1%, US investor will gain only +1% (+2 1%). If
EURO depreciates by 2% or more, US investor will not gain anything or incur loss. If EURO
appreciates, US investor will gain, +2% and interest rate differential

2) Covered Arbitrage
International investors would like to avoid the foreign exchange risk, thus interest
arbitrage is usually covered. The investor converts the domestic currency for foreign
currency at the current spot rate for the purpose of investment. At the same time, investor
sells forward the amount of foreign currency which he is investing plus the interest that he
will earn so as to coincide with maturity of foreign investment.
The covered interest arbitrage refers to spot purchase of foreign currency to make
investment and offsetting simultaneous forward sale of foreign currency to cover foreign
exchange risk. When treasury bills mature, the investor will get the domestic currency
equivalent of foreign investment plus interest without a foreign exchange risk.