International Financial Management

Q.1a) Explain various tools and techniques of Foreign Risk

Management.
Ans. The value of a currency changes frequently due to various factors in the
market such as inflation, interest rates, current account deficits, trade terms, political

and economic performance etc. That ultimately affects firms and individuals engaged

in international transactions. Foreign exchange risk is a form of financial risk that

arises from the change in the price of one currency against another. Whenever

investors or companies have assets or business operations across national borders,

they face forex risk. Such risk must be managed in order to ensure better cash flows,

manage unsystematic risks, avoid external financing, avoid financial distress,

enhance shareholders wealth, and increases investor confidence.

Forward contracts:
A forward contract is a commitment to buy or sell a specific amount
of foreign currency at a later date or within a specific time period
and at an exchange rate stipulated when the transaction is struck.
The delivery or receipt of the currency takes place on the agreed
forward value date.

A forward transaction cannot be cancelled but can be closed out at

any time by the repurchase or sale of the foreign currency amount
on the value date originally agreed upon. Any resultant gains or
losses are realized on this date.

Generally, there is variation in the forward price and spot price of a

currency. In case the forward price is higher than the spot price, a
forward premium is used whereas if the forward price is lower, a
forward discount is used.
To compute annual percentage premium or discount, the
following formula may be used:
Forward premium or discount = (Forward rate – Spot rate)/Spot
rate x 360/Number of days under the forward contract

In this formula, the exchange rate is expressed in terms of domestic

currency units per unit of foreign currency. To illustrate, if the spot
price of 1 US dollar is Indian rupees 39.3750 on a given date and its
180-day forward price quoted is Rs 39.8350, the annualized
forward premium works out to 0.92, as under:

Forward premium or discount = (39.8350 – 39.3750) * 360/180 =

0.92

The forward differential is known as swap rate. By adding the

premium (in points) to or subtracting the discounts (in points) from
the spot rate, the swap rate can be converted into an outright rate.
These forward premiums and discounts reflect the interest rate
differentials between the respective currencies in the inter-bank
market.

If a currency with higher interest rates is sold forward, sellers enjoy

the advantage of holding on to the higher earning currency during
the period between agreeing upon the transaction and its maturity.

Buyers are at a disadvantage since they must wait until they can
obtain the higher earning currency. The interest rate disadvantage
is offset by the forward discount. In the forward market, currencies
are bought and sold for future delivery, usually a month, three
months, six months, or even more from the date of transaction.
Future contracts:
Commonly used by MNEs as hedging instruments, future contracts
are standardized contracts that trade on organized futures markets
for a specific delivery date only.

The major difference in forward and future markets is

summarized as follows:
i. The forward contract does not have lot size and is tailored to the
need of the exporter, whereas the futures have standardized round
lots.

ii. The date of delivery in forward contracts is negotiable, whereas

future contracts are for particular delivery dates only.

iii. The contract cost in future contracts is based on the bid/offer

spread, whereas brokerage fee is charged for futures trading.

iv. The settlement of forward contracts is carried out only on

expiration date, whereas profits or losses are paid daily in case of
futures at the close of trading.

v. Forward contracts are issued by commercial banks, whereas

international monetary markets (for example, the Chicago
Mercantile Exchange) or foreign exchanges issue futures contracts.
Options:
Foreign currency options provide the holder the right to buy or sell
a fixed amount of foreign currency at a pre-arranged price, within a
given time. An option is an agreement between a holder (buyer) and
a writer (seller) that gives the holder the right, but not the
obligation, to buy or sell financial instruments at a time through a
specified date.
Thus, under an option, although the buyer is under no obligation to
buy or sell the currency, the seller is obliged to fulfil the obligation.

This provides the flexibility to the holder of a foreign currency

option not to buy or sell the foreign currency at the pre-determined
price, unlike in a forward contract, if it is not profitable. Price at
which the option is exercised, i.e., at which a foreign currency is
bought or sold, is known as strike price. Both currency call and put
options can be purchased on an exchange.

There are two types of foreign currency options:

Call option gives the holder the right to buy foreign currency at a
pre-determined price. It is used to hedge future payables. Put
option gives the holder the right to sell foreign currency at a pre-
determined price. It is used to hedge future receivables.

Foreign currency options are used as effective hedging instruments

against exchange- rate risks as they offer more flexibility than
forward or future contracts because no obligation is required on the
part of the buyer under the currency options.

Swap:
In order to hedge long-term transactions to currency rate
fluctuations, currency swaps are used. Agreement to exchange one
currency for another at a specified exchange rate and date is termed
as currency swap. Currency swaps between two parties are often
intermediated by banks or large investment firms. .

Foreign exchange swap accounts for about 55.6 per cent of the
average daily foreign exchange turnover of the world, whereas spot
deals account for 32.6 per cent and outright forward for 11.7 per
cent.

Buying a currency at a lower rate in one market for immediate

resale at higher rate in another with an objective to make profit
from divergence in exchange rates in different money markets is
known as ‘currency arbitrage’. To capitalize on discrepancy in
quoted prices, arbitrage is often used to make riskless profits.

Q2) a) Give the distinction between Domestic and International Finance

Ans.

International finance is different from domestic finance in many aspects and first and
the most significant of them is foreign currency exposure. There are other aspects
such as the different political, cultural, legal, economical, and taxation environment.
International financial management involves a lot of currency derivatives whereas
such derivatives are very less used in domestic financial management.
The term ‘International Finance’ has not come from Mars. It is similar to the domestic
finance in many of the aspects. If we talk on a macro level, the most important
difference between international finance and domestic finance is of foreign currency
or to be more precise the exchange rates.

In domestic financial management, we aim at minimizing the cost of capital while

raising funds and try optimizing the returns from investments to create wealth
for shareholders. We do not do any different in international finance. So, the
objective of financial management remains same for both domestic and international
finance i.e. wealth maximization of shareholders. Still, the analytics of international
finance is different from domestic finance.
INTERNATIONAL VS DOMESTIC FINANCE
Following are the major differences:
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.
There may be such more points of difference between international and domestic
financial management. Mentioned above are a list of major differences. We need to
consider each of them before taking any decision involving multinational financial
environment.

b) What are the factors influencing exchange rates?

Exchange rates are one of the most watched and analysed economic measures across the world
and are a key indicator of a country's economic health. The exchange rate can be defined as the
rate at which one country's currency may be converted into another. Rates are not just important
to governments and large financial institutions. They also matter on a smaller scale, having an
impact on the real returns of an investor's portfolio.

There are several forces behind exchange rate movements and it is useful to have a basic
understanding of how these affect one country's trading relationship with other countries. Strong
currencies make a nation's exports more expensive and imports from foreign markets cheaper,
whereas weaker currencies make exports cheaper and imports more expensive. Higher
exchange rates adversely affect a country's balance of trade but lower exchange rates have a
positive effect on it. This article looks at 7 of the main factors that cause changes and fluctuations
in exchange rates and outlines the reasons for their volatility.

Common Factors Affecting Exchange

Rates
 Inflation Rates
Changes in inflation cause changes in currency exchange rates. Generally speaking, a country
with a comparatively lower rate of inflation will see an appreciation in the value of its currency.
The price of goods and services increases at a slower rate when inflation is low. Countries with a
continually low inflation rate exhibit an increasing currency value, whereas a country with higher
 inflation typically experiences depreciation of its currency and this is usually accompanied by
higher interest rates.

 Interest Rates
Interest rates, inflation and exchange rates are all correlated. Central banks can influence both
inflation and exchange rates by manipulating interest rates. Higher interest rates offer lenders a
higher return compared to other countries. Any increase in a country's interest rate causes its
currency to increase in value as higher interest rates mean higher rates to lenders, thus
attracting more foreign capital, which in turn, creates an increase in exchange rates.

 Recession
In the event a country's economy falls into a recession, its interest rates will be dropped,
hindering its chances of acquiring foreign capital. The consequence of this is that its currency
weakens in comparison to that of other countries, thereby lowering the exchange rate.

 Current Account/Balance of Payments

A country's current account reflects its balance of trade and earnings on foreign investment. It
comprises of the total number of transactions including exports, imports and debt. A deficit in its
current account comes as a result of spending more of its currency on importing products than
through exports. This has the effect of lowering the country's exchange rate to the point where
domestic goods and services become cheaper than imports, thereby generating domestic sales
and exports as the goods become cheaper on international markets.

 Terms of Trade
Terms of trade relate to a ratio which compares export prices to import prices. If the price of a
country's exports increases by a higher rate than its imports, its terms of trade will have
improved. Increasing terms of trade indicate a greater demand for a country's exports. This, in
turn, results in an increase in revenue from exports which has the effect of raising the demand for
the country's currency and an increase in its value. In the event the price of exports rises by a
lower rate than its imports, the currency's value will decline in comparison to that of its trading
partners.

 Government Debt
Government debt is public debt or national debt owned by the central government. Countries with
large public deficits and debts are less attractive to foreign investors and are thus less likely to
acquire foreign capital which leading to inflation. Foreign investors will forecast a rise government
debt within a particular country. As a result, a decrease in the value of this country's exchange
rate will follow.
 Political Stability and Performance
A country's political state and economic performance can affect the strength of its currency. A
country with a low risk of political unrest is more attractive to foreign investors, drawing
investment away from other countries perceived to have more political and economic risk. An
increase in foreign capital leads to the appreciation in the value of the country's currency, but
countries prone to political tensions are likely to see a depreciation in the rate of their currency.
All of the factors described above determine foreign exchange rate fluctuations and the
exchange rate of the currency in which an investor's portfolio holds the majority of its investments
determines its real return. A declining exchange rate thus decreases the purchasing power of
income and capital gains derived from any returns. Overall, exchange rates are determined by
many complex factors and although these cannot always be easily explained, it is important for
investors to have some understanding of how currency values and exchange rates play a key
role both in the economy and in the rate of return on their investments.

Q3) b) Foreign Exchange Market

An. Meaning:

Foreign exchange market is the market in which foreign currencies

are bought and sold. The buyers and sellers include individuals,
firms, foreign exchange brokers, commercial banks and the central
bank.

Like any other market, foreign exchange market is a system, not a

place. The transactions in this market are not confined to only one
or few foreign currencies. In fact, there are a large number of
foreign currencies which are traded, converted and exchanged in
the foreign exchange market.

Functions of Foreign Exchange Market:

Foreign exchange market performs the following three
functions:
1. Transfer Function:
It transfers purchasing power between the countries involved in the
transaction. This function is performed through credit instruments
like bills of foreign exchange, bank drafts and telephonic transfers.

2. Credit Function:
It provides credit for foreign trade. Bills of exchange, with maturity
period of three months, are generally used for international
payments. Credit is required for this period in order to enable the
importer to take possession of goods, sell them and obtain money to
pay off the bill.

3. Hedging Function:
When exporters and importers enter into an agreement to sell and
buy goods on some future date at the current prices and exchange
rate, it is called hedging. The purpose of hedging is to avoid losses
that might be caused due to exchange rate variations in the future.

Kinds of Foreign Exchange Markets:

Foreign exchange markets are classified on the basis of
whether the foreign exchange transactions are spot or
forward accordingly, there are two kinds of foreign
exchange markets:
(i) Spot Market,

(ii) Forward Market.

(i) Spot Market:

Spot market refers to the market in which the receipts and
payments are made immediately. Generally, a time of two business
days is permitted to settle the transaction. Spot market is of daily
nature and deals only in spot transactions of foreign exchange (not
in future transactions). The rate of exchange, which prevails in the
spot market, is termed as spot exchange rate or current rate of
exchange.

The term ‘spot transaction’ is a bit misleading. In fact, spot

transaction should mean a transaction, which is carried out ‘on the
spot’ (i.e., immediately). However, a two day margin is allowed as it
takes two days for payments made through cheques to be cleared.

(ii) Forward Market:

Forward market refers to the market in which sale and purchase of
foreign currency is settled on a specified future date at a rate agreed
upon today. The exchange rate quoted in forward transactions is
known as the forward exchange rate. Generally, most of the
international transactions are signed on one date and completed on
a later date. Forward exchange rate becomes useful for both the
parties involved in the transaction.

Forward Contract is made for two reasons:

(a) To minimize the risk of loss due to adverse changes in the
exchange rate (through hedging);

(b) To make profit (through speculation).

c) International Finance
International Finance is an important part of financial economics. It mainly discusses
the issues related with monetary interactions of at least two or more countries.
International finance is concerned with subjects such as exchange rates of
currencies, monetary systems of the world, foreign direct investment (FDI), and other
important issues associated with international financial management.
Like international trade and business, international finance exists due to the fact
that economic activities of businesses, governments, and organizations get affected
by the existence of nations. It is a known fact that countries often borrow and lend
from each other. In such trades, many countries use their own currencies. Therefore,
we must understand how the currencies compare with each other. Moreover, we
should also have a good understanding of how these goods are paid for and what is
the determining factor of the prices that the currencies trade at.

Importance of International Finance

International finance plays a critical role in international trade and inter-economy
exchange of goods and services. It is important for a number of reasons, the most
notable ones are listed here −
 International finance is an important tool to find the exchange rates, compare inflation
rates, get an idea about investing in international debt securities, ascertain the economic
status of other countries and judge the foreign markets.
 Exchange rates are very important in international finance, as they let us determine the
relative values of currencies. International finance helps in calculating these rates.
 Various economic factors help in making international investment decisions. Economic
factors of economies help in determining whether or not investors’ money is safe with
foreign debt securities.
 Utilizing IFRS is an important factor for many stages of international finance. Financial
statements made by the countries that have adopted IFRS are similar. It helps many
countries to follow similar reporting systems.
 IFRS system, which is a part of international finance, also helps in saving money by
following the rules of reporting on a single accounting standard.
 International finance has grown in stature due to globalization. It helps understand the
basics of all international organizations and keeps the balance intact among them.
 An international finance system maintains peace among the nations. Without a solid
finance measure, all nations would work for their self-interest. International finance helps
in keeping that issue at bay.
 International finance organizations, such as IMF, the World Bank, etc., provide a
mediators’ role in managing international finance disputes.
The very existence of an international financial system means that there are
possibilities of international financial crises. This is where the study of international
finance becomes very important. To know about the international financial crises, we
have to understand the nature of the international financial system.
Without international finance, chances of conflicts and thereby, a resultant mess, is
apparent. International finance helps keep international issues in a disciplined state.
 Environment
Ques3

A) Bhopal Gas Tragedy

Ans. The MIC gas leak in Bhopal in 1984 is probably the worst
industrial tragedy which is related to air pollution. A US $ 25
million pesticide plant at Bhopal was set up in 1969 by Union
Carbide, the seventh largest producer of chemicals in the world. The
American Company justified the existence of the plant by claiming
that India loses US $ 5,000 million annually to pests.

During the manufacturing process, highly volatile and toxic Methyl-

ISO- Cynate (MIC) was combined with Alpha-Nepthol to produce
Sevin, a patent pesticide which was widely used in India at that
time. MIC is produced by treating Methylamin with Phosgene.
Phosgene, a lethal gas used during First World War against
Germany, is derived by mixing toxic carbon monoxide gas with
chlorine.

Union Carbide renewed its collaboration with its Indian counterpart

in 1983 for the manufacture of MIC based pesticide on the specific
understanding that the Indian plant would acquire the relevant
technology from the parent company to handle emergency
situations.

Environmental Impacts and Victims:

On the night of December 1, 1984 the most tragic industrial disaster
occurred in the city of Bhopal. On that night of the tragedy, MIC
leaked from the plant in substantial quantity. A cloud of gas
engulfed Bhopal city. The tragedy took a toll of over 2000 human
lives and a similar number of cattle’s. Five thousand people were
seriously affected and over one lakh were taken ill.

Health Effects:
The following effects of MIC on people were noticed by
doctors after two days of tragedy:
(a) Irritation of the eyes, nausea and vomiting, chest pain and
difficulties in breathing.

(b) Accumulation of fluid in the lungs and destruction of lung

tissues and subsequent complications include anoxia or insufficient
oxygen in the blood and cardiac arrest.

Responsibility for the Tragedy:

1. The management of the Union Carbide was responsible for failing
to set the same technology standards in the Indian Plant as in its
other plants operated in USA.

2. The Indian government was responsible for failing to enforce

environmental standards on the company.

3. The State government was responsible for failing to control

population movements to factory site.

A US $ 20 billion compensation suit has been filed against Union

Carbide. A number of victims of the Bhopal tragedy have filed
similar suits in various courts in the United States.

c) Effects of Landslide

Ans. Landslides are among the many natural disasters causing massive
destructions and loss of lives across the globe. According to a survey study by
the International Landslide Centre at Durham University, UK, 2,620 fatal
landslides occurred between 2004 and 2010. These landslides resulted in the
death of over 32,322 people. The figure does not include landslides caused
by earthquakes. This research result is astonishing considering the number of
people killed by landslides. It is, thus, paramount to know the causes and
warning signs of a potential landslide to minimize losses.

A landslide, sometimes known as landslip, slope failure or slump, is an

uncontrollable downhill flow of rock, earth, debris or the combination of the
three. Landslides stem from the failure of materials making up the hill slopes
and are beefed up by the force of gravity. When the ground becomes
saturated, it can become unstable, losing its equilibrium in the long run. That’s
when a landslide breaks loose. When people are living down these hills or
mountains, it’s usually just a matter of time before disaster happens.

Landslides are a major catastrophe the world as it is widespread andsignificant

impact, including Malaysia. The effects of catastrophic landslides isdangerous to
humans and to other living thingsFor example, the slope of the saturated with
water to form debris flows or mudflows. Concentrated mixture of rock and mud
may destroy the trees, houses, andcars and blocking the bridge. Mud mixed with
river flow can cause devastatingflooding along the route.Similarly, the ice floes
formed in the river caused by ice clogging the rivers andflows more slowly.
However, it can produce enough energy to destroy the bridge. Icemay accumulate
on the edge or on top of weak layers of snow or unstable causescrash occurred.

No one can outrun an approaching landslide or mudflow. They are so fast and
powerful that they wipe out trees and rocks in their way. They cause massive
destruction in many ways such as:

Loss of lives:
Landslides and mudslides kill between 25 and 50 people every year in the USA
alone. Globally, it is believed that the number of deaths is highly underestimated.

In total, 2,620 fatal landslides were recorded worldwide during the 2004 and 2010
period of the study, causing a total of 32,322 recorded fatalities .

Destruction of property:
In 1980, Mount St Helens in Washington USA erupted and causes a rock debris
landslide believed to be the biggest in history. The landslide traveled about 14 miles,
wiping away highway bridges, buildings, and roads. It is known that the amount of
debris in this avalanche can fill 250 million dump trucks .

Economic costs:
Landslides bring huge costs to communities and cities affected, by clean up and
rebuilding destroyed infrastructure. In 2005 it cost the USA $3.5 billion in damage
repair .

Destruction natural environment:

Debris flows usually uproot trees and wipe out vegetation and wildlife in its path.