INTERNATIONAL FINANCE

THEORETICAL SHORT NOTES

(BIT.LY/IF-NOTES)

NOTE: MOST DATA BELOW HAS BEEN COPY-PASTED FROM VAROUS SOURCES.
(UTILISE AT YOUR OWN DISCRETION, FOR REFERENCE PURPOSES ONLY)

Note: Only the seemingly important and relevant theoretical topics are covered here, not the
entire syllabus.

LQP – Indicates Last Year’s Question Paper (BFIA/BMS)

UNIT 1
International Trade
• International trade is a field in economics that applies microeconomic models to help
understand the international economy.
• It is the exchange of goods and services across international borders or territories
• Its content includes basic supply-and-demand analysis of international markets; firm
and consumer behavior; perfectly competitive, oligopolistic, and monopolistic market
structures; and the effects of market distortions
• The objective is to understand the effects of international trade on individuals and
businesses and the effects of changes in trade policies and other economic conditions.
There are two basic types of trade between countries:
1. the first in which the receiving country itself cannot produce the goods or provide the
services in question, or where they do not have enough to be a self-sufficient
economy.
2. the second, in which they have the capability of producing the goods or supplying the
services, but still import them
International Finance
• International finance applies macroeconomic models to help understand the
international economy.
• Its focus is on the interrelationships among aggregate economic variables such as
GDP, unemployment rates, inflation rates, trade balances, exchange rates, interest
rates, and so on.
• This field expands basic macroeconomics to include international exchanges. Its focus
is on the significance of trade imbalances, the determinants of exchange rates, and the
aggregate effects of government monetary and fiscal policies.
International finance plays a critical role in international trade and inter-economy exchange
of goods and services. International finance is an important tool to find the exchange rates,
compare inflation.

International Business
• International business is the term used for business conducted all over the world.
• These transactions include the transfer of goods, services, technology, managerial
knowledge, and capital to other countries. International business involves exports and
imports and business processes and channel beyond simple trade.
• International Business is also referred to as Global Business and can encompass:
- Exporting goods and services.
- Giving license to produce goods in the host country.
 - Starting a joint venture with a company.
- Opening a branch for producing & distributing goods in the host country
- Providing managerial services to companies in the host country.

International Trade Financing (LQP)

The five major processes of transaction in international trade are
the following −
1. Prepayment: Prepayment occurs when the payment of a debt or instalment payment is
done before the due date. A prepayment can include the entire balance or any
upcoming part of the entire payment paid in advance of the due date. In prepayment,
the borrower is obligated by a contract to pay for the due amount. Examples of
prepayment include rent or loan repayments.
2. Letter of Credit: A Letter of Credit is a letter from a bank that guarantees that the
payment due by the buyer to a seller will be made timely and for the given amount. In
case the buyer cannot make payment, the bank will cover the entire or remaining
portion of the payment.
3. Sight Draft − It is a kind of bill of exchange, where the
exporter owns the title to the transported goods until the
importer acknowledges and pays for them. Sight drafts are
usually found in case of air shipments and ocean shipments
for financing the transactions of goods in case of
international trade.
4. Consignment: It is an arrangement to leave the goods in the possession of another
party to sell. Typically, the party that sells receives a good percentage of the sale.
5. Open Account: Open account is a method of making payments for various trade
transactions. In this arrangement, the supplier ships the goods to the buyer. After
receiving and checking the concerned shipping documents, the buyer credits the
supplier's account in their own books with the required invoice amount.

Theories of International Trade

(LQP – Relative Advantage, HO Model)

Theory of Mercantilism (mid-16th century)

• A trade theory prevailed during 16th to 19th centuries
• The wealth of a nation is measured based on its accumulated wealth in terms of gold
and silver
• Nations should accumulate wealth by encouraging exports (subsidies) and
discouraging imports (tariffs)
• Theory of mercantilism aims at creating trade surplus and in turn accumulate nation’s
wealth
• Mercantilists constantly demanded state intervention in trade relations with foreign
partners to ensure a trade surplus

Absolute Advantage Theory

• Propounded by Adam Smith, ‘An Enquiry into the Nature and Causes of the Wealth
of Nations’, 1776
• There is international benefit from trade – Everyone better off without making anyone
worse off
• When one country can produce a unit of good with less cost than another country, the
first country has an absolute (cost) advantage in producing that good
 • Cost is considered based on number of labor units used.
• According to the absolute advantage theory, international trade is a positive sum
game, because there are gains for both countries from the exchange.
• Unlike mercantilism this theory measures the nation's wealth by the living standards
of its people and not by gold and silver.

Assumptions:
● Trade exists between two countries
• Only two goods are produced and traded
• Assumes there is an absolute advantage balance among nations
• Labor is the only factor of production and its productivity remains the same

Comparative Advantage Theory

• Propounded by David Ricardo, ‘The Principles of Political Economy & Taxation’,
1817.
• Nations can still gain from trade even without an absolute advantage.
• Facilitator – Difference in opportunity cost
• A country has a Comparative Advantage in producing a good if the opportunity cost
of producing that good in terms of other goods is lower in that country compared to
other countries
• Even if countries do not have an absolute advantage, they can gain from trade by
allocating resources based on their comparative advantage and trade with each other
• Trade leads to international specialization. With labor as the only factor, it moves
from relatively less efficient industries to relatively more efficient industries
Assumptions – Same as previous model

The Heckscher – Ohlin Model

• Cause of trade
– International differences in labor productivity as per Ricardian view
– Differences in countries resources (H-O model.)
• Developed by Eli Heckscher and Bertil Ohlin
Also called Factor-proportions Theory – because it discusses:
– The proportions in which different factors of production are available in different
countries, and
– The proportion in which they are used in producing different goods

Assumptions
• Assumption of Perfect Competition
• Productivity of labor constant for both products and in both countries
• Labor is perfectly mobile between sectors but immobile between countries
• No technological innovation in any of the economies

Based on these postulates, the H-O model predicts that the capital surplus country specializes
in the production and export of capital-intensive goods and the labor surplus country
specializes in the production and export of labor-intensive goods

Gains from Trade: Trade leads to convergence of relative prices, which in turn has strong
effect on the relative earnings of the factors of production.
Example: the US has long been a substantial exporter of agricultural goods, reflecting in part
its unusual abundance of arable land. China exports labor-intensive manufactured goods
reflecting China’s relative abundance of low-cost labor

Leontief Paradox
Since US was relatively abundant in capital compared to other nations, the US would be an
exporter of capital-intensive goods and an importer of labor-intensive goods. However,
Leontief found that US exports were less capital intensive than US imports. This has become
known as Leontief paradox

Rational: US has a special advantage in producing new and innovative products. Such
products may be less capital intensive and heavily use skilled labor and innovative
entrepreneurship Ex: Computer software

National Competitive Advantage (Porter, 1990)

• Why does a nation achieve success internationally in a particular industry?
• Why are firms based in a particular nation able to create and sustain competitive
advantage against its global competitors in a particular field?
• Introduced by Michael Porter, a famous Harvard Business Professor in 1990
• Believes the standard classical theories on comparative advantage provides only a
partial explanation – They do not say why these countries are more productive
compared to others
• A nation attains competitive advantage if its firms are competitive. And, firms
become competitive through innovations
• Innovation – either technical improvements to the product or to the production
process
• Four determinants of National Competitive Advantage (“Porter’s Diamond”) are:
1. Factor Conditions: Nations position of factors of production
2. Demand Conditions: Nature of home demand for industry’s product or service
3. Related and Supporting Industries: Presence of supplier/related industries that are
nationally competitive
4. Firm Strategy, Structure and Rivalry: Conditions in nation governing how companies
are created, organized and managed.

Balance of Payments: The balance of payments (BOP), also known as balance of

international payments, summarizes all transactions that a country's individuals, companies
and government bodies complete with individuals, companies and government bodies outside
the country. These transactions consist of imports and exports of goods, services and capital,
as well as transfer payments, such as foreign aid and remittances.

The balance of payments divides transactions in two accounts: the current account and

the capital account. 

- The current account includes transactions in goods, services, investment income and current

transfers. 
-The capital account, broadly defined, includes transactions in financial instruments and
central bank reserves. (The current account is included in calculations of national output,
while the capital account is not.)
Note: The sum of all transactions recorded in the balance of payments must be zero. The
reason is that every credit appearing in the current account has a corresponding debit in the
capital account, and vice-versa. If a country exports an item (a current account credit), it
effectively imports foreign capital when that item is paid for (a capital account debit).

Balance of payments and international investment position data are critical in formulating
national and international economic policy. Certain aspects of the balance of payments data,
such as payment imbalances and foreign direct investment, are key issues that a nation's
policymakers seek to address.

Trade Balance (BOT): The balance of trade is the difference between the value of a country's
imports and exports for a given period. The balance of trade is the largest component of a
country's balance of payments.
Balance of Goods & Services: This is the balance between exports and imports of goods and
services.
Current Account Balance: This is the net balance on the entire current account. Negative CA
Balance implies a deficit, when positive it is in surplus.

Exchange Rate Mechanisms: An exchange rate mechanism (ERM) is a device used to

manage a country's currency exchange rate relative to other currencies. It is part of an
economy's monetary policy and is put to use by central banks.
1. Current Monetary System
A. Floating Rate: A floating exchange rate is a regime where the currency price of a
nation is set by the forex market based on supply and demand relative to other
currencies. Floating exchange rate systems mean long-term currency price changes
reflect relative economic strength and interest rate differentials between countries.
Short-term moves in a floating exchange rate currency reflect speculation, rumours,
disasters, and everyday supply and demand for the currency. If supply outstrips
demand that currency will fall, and if demand outstrips supply that currency will rise.
B. Fixed Rate: A fixed exchange rate is a regime applied by a government or central
bank ties the country's currency official exchange rate to another country's currency
or the price of gold. The purpose of a fixed exchange rate system is to keep
a currency's value within a narrow band. Fixed rates provide greater certainty for
exporters and importers. Fixed rates also help the government maintain low inflation,
which, in the long run, keep the interest rates down and stimulates trade and
investment. 
C. Managed Float Rate /Dirty Rate (LQP): A dirty float is a floating exchange rate where
a country's bank occasionally intervenes to change the direction or the pace of change
of a country's currency value. In most instances, the central bank in a
dirty float system acts as a buffer against an external economic shock before its
effects become disruptive to the domestic economy. A dirty float is also known as a
"managed float." Many developing nations seek to protect their domestic industries
and trade by using a managed float where the central bank intervenes to guide the
currency. The frequency of such intervention varies. For example, the Reserve Bank
of India closely manages the rupee within a very narrow currency band while the
Monetary Authority of Singapore allows the local dollar to fluctuate more freely in an
undisclosed band.

1. Gold Standard: The gold standard is a monetary system where a country's

currency or paper money has a value directly linked to gold. With the gold
 standard, countries agreed to convert paper money into a fixed amount of gold. A
country that uses the gold standard sets a fixed price for gold and buys and sells
gold at that price. That fixed price is used to determine the value of the currency.
For example, if the U.S. sets the price of gold at $500 an ounce, the value of the
dollar would be 1/500th of an ounce of gold. The gold standard is not currently
used by any government. The appeal of a gold standard is that it arrests control of
the issuance of money out of the hands of imperfect human beings. With the
physical quantity of gold acting as a limit to that issuance, a society can follow a
simple rule to avoid the evils of inflation.

2. Gold Exchange Standard: This is an extension of the Gold Standard. The

authorities of a nation stand ready to covert at a fixed rate, the paper currency
issued by them into the paper currency of another country which is operating at a
gold standard. Thus, if rupees are freely convertible into dollars and dollars turn
into gold, the rupee can say to be on a gold exchange standard.

3. Bretton Woods System (LQP): Bretton Woods Agreement established a new

international monetary system. The goal was to create an efficient foreign
exchange system, prevent competitive devaluations of currency and promote
international economic growth. Under this system, other currencies were pegged
to the value of the USD, which in turn was pegged to the price of the gold. It came
to an end in 1970, when US announced that it would no longer exchange gold for
the US currency, as gold supply was no longer adequate to cover the number of
dollars in circulation. (Primary designer of this system was John Maynard
Keynes)
After the system collapsed, the countries were free to choose any exchange agreement for
their currency except pegging its value to the price of gold.

European Monetary Union

The European Monetary Union (EMU) is a system of policies that manages the budget, and
more importantly, facilitates the admission of new members into the EU. Each state is
required to give a percentage of money to the EMU. That money is used for international
trade, rural development, environmental protection, border protection, and promoting human
rights. The money is also used to assist members when they are in financial and economic
trouble. Greece is a recent example; the EU gave billions of dollars to help that country repay
debt and recover from a recession. When new states join the EU, the EMU contributes to the
three-stage process (which we'll talk about later). The process ultimately leads to two things:
A state's financial contribution to the EU and its implementation of the Euro currency.

Before you move ahead: The Bretton Woods agreement also created two important
institutions namely the IMF & World Bank group. The purpose of IMF was to monitor
exchange rates and lend reserve currency to nations that needed it to support their currencies
and settle their debts.
The World Bank group initially called the International Bank for reconstruction and
Development was established to provide assistance to countries that had been physically and
financially devastate by World War II.

IMF
The International Monetary Fund (IMF) is based in Washington, D.C., and currently consists
of 189 member countries, each of which has representation on the IMF's executive board in
proportion to its financial importance, so that the most powerful countries in the global
economy have the most voting power. The IMF's website describes its mission as "to foster
global monetary cooperation, secure financial stability, facilitate international trade, promote
high employment and sustainable economic growth, and reduce poverty around the world."
The IMF's primary methods for achieving these goals are monitoring, capacity building, and
lending.

1. Surveillance
The IMF collects massive amounts of data on national economies, international trade, and the
global economy in aggregate, as well as providing regularly updated economic forecasts at
the national and international level. These forecasts, published in the World Economic
Outlook, are accompanied by lengthy discussions of the effect of fiscal, monetary, and trade
policies on growth prospects and financial stability.

2. Capacity Building
The IMF provides technical assistance, training, and policy advice to member countries
through its capacity building programs. These programs include training in data collection
and analysis, which feed into the IMF's project of monitoring national and global economies.

3. Lending
The IMF makes loans to countries that are experiencing economic distress in order to prevent
or mitigate financial crises. Members contribute the funds for this lending to a pool based on
a quota system. 

World Bank (LQP)

The World Bank was established in 1946 as a twin institution with the IMF (International
Monetary Fund) as a result of the Bretton Woods Conference. It assists reconstruction and
development of the needy countries through long- and medium-term loans. It pays special
attention to the development of under-developed countries. It not only grants loans out of its
own funds, but it also assists private foreign investment by guaranteeing or participating in
loans and investments made by private investors and coordinates the lending activities of the
rich countries at a governmental level. It has thus helped in raising productivity and the living
standards in developing countries.

The World Bank advances loans to the developing countries subject to the following
conditions:
(a) The overall economy of the borrowing country is soundly operated
(b) If the overall economic plans would reinforce the basic soundness of economy, and
(c) The projects which the bank is asked to finance have been carefully prepared and are
economically and financially justified.

The World Bank has become a part of a broadening stream of financial and technical
assistance to the less developed countries. Although now other sources and institutions have
also joined in the task which the Bank pioneered with such imagination and purposiveness, it
has not detracted from the importance of the part which the Bank is playing in mobilizing
international assistance to developing countries.
 UNIT 2
Direct Quotation-Indirect Quotation (LQP)
Direct Quotation: A direct quote is a foreign exchange rate involving a quote in fixed units of
foreign currency against variable amounts of the domestic currency.

Format - Base/Quote
USD/INR = 70 (DQ for Indian)

Indirect Quotation: The term indirect quote is a currency quotation in the foreign exchange
market that expresses the amount of foreign currency required to buy or sell one unit of the
domestic currency.
INR/USD = 0.01428 (IDQ for Indian)
 
Retail Market: The market in which travellers and tourists exchange one currency for another
in the form of currency notes or traveller’s cheques. The total turnover and average
transaction size are very small. The spread between buying and selling prices is large. In
retail market, entities who quote forex rates, but don’t make a two-way market are the
secondary price makers. For instance, hotels, shops catering to tourists buy foreign currency.
(Bid-Ask spreads are much wider)

Wholesale Market: The foreign exchange market where the major participants are
commercial banks, investment institutions, non-financial corporations and central banks. The
average transaction size is very large. The primary price makers quote a two-way price – a
price to buy currency X against Y, and a price to sell X against Y. This group includes
commercial banks, some large investment dealers and a few large corporations. (Bid-Ask
spreads are narrow)
Note: Price takers simply take the prices quoted by the primary price makers, and buy/sell
currency for their own purposes, but do not make a market themselves. Don’t take an active
position in the market to profit from exchange rate fluctuations.

Settlement Dates
- In spot transaction, settlement date is two business days ahead for European/Asian
currencies traded against the dollar.
- To reduce credit risk, both transfers should take place on the same day.
- In case there is a holiday on the day of transfer, then the transfer is shifted to the next
business day
- For forward transactions, we find the date of spot transaction and add one calendar
month
- If in a forward transaction, the value date is ineligible because of some bank holiday,
then it is shifted to next available business day, however it must not take you into the
next calendar month (in that case it is shifted backward)
- Broken Date: Forward contracts for maturities which are not in whole months
- Short Date: Transactions that call for settlement before the spot date.

Early Delivery, Extension or Cancellation of Forward Contracts (LQP – Fwd-Fwd-In)

1. Swap In: When long position is taken in the spot market and short position is taken in
the forward market
2. Swap Out: When short position in spot market and long position in forward market
 3. Forward-Forward-In: When long position is taken in near forward and short position
in distant forward
4. Forward-Forward Out: When short position in near forward and long position in
distant forward

Early delivery of a transaction is of two types:

- Information on date of early delivery
- Information before the date of early delivery
Date of Delivery Before Date of Delivery
Importer Swap In Fwd-Fwd-In
Exporter Swap Out Fwd-Fwd Out

Extension
- Information on maturity date
- Information to bank before maturity date
Date of Delivery Before Date of Delivery
Importer Swap Out Fwd-Fwd-Out
Exporter Swap In Fwd-Fwd In

Cancellation – Just take opposite position of what you had earlier head

Purchasing Power Parity (PPP) (LQP)

The alternative to using market exchange rates is to use purchasing power parities (PPPs).
The purchasing power of a currency refers to the quantity of the currency needed to purchase
a given unit of a good, or common basket of goods and services. Purchasing power is clearly
determined by the relative cost of living and inflation rates in different countries. Purchasing
power parity means equalising the purchasing power of two currencies by taking into account
these costs of living and inflation differences.
This index, devised by The Economist, calculates how many units of a local currency are
needed to purchase a Big Mac. Exchange rates can then be adjusted according to how much
local currency is required.
For example, if 200 Japanese yen (¥) are required to buy a Big Mac in Tokyo, and $2 are
required in New York, the 'value' of currencies are $1 = ¥100. This can be used to adjust the
value of Japanese GDP, so that if GDP in Japan is ¥100 trillion, its value will be $1 trillion.
PPP Formula = Cost of good X in currency 1/Cost of good X in currency 2

Interest Rate Parity (IRP)

Interest rate parity (IRP) is a theory in which the differential between two countries is equal
to the differential between the forward exchange rate and the spot exchange rate. Interest rate
parity plays an essential role in foreign exchange markets, connecting interest rates, spot
exchange rates and foreign exchange rates.
The difference between the forward rate and spot rate is known as swap points. If this
difference (forward rate minus spot rate) is positive, it is known as a forward premium; a
negative difference is termed a forward discount. A currency with lower interest rates will
trade at a forward premium in relation to a currency with a higher interest rate. The basic
premise of interest rate parity is that hedged returns from investing in different currencies
should be the same, regardless of the level of their interest rates.

[If one country offers a higher risk-free rate of return in one currency than that of another, the
country that offers the higher risk-free rate of return will be exchanged at a more expensive
future price than the current spot price.]

Forward Rate as an unbiased predictor (LQP)

In statistical terms, "bias" is generally considered to be the variance between a prediction and
the actual outcome, so an unbiased predictor is one that, one average, closely forecasts the
future behaviour of the variable under consideration. In the currency markets, an unbiased
predictor is the theory that forward exchange rates for delivery at a specific date in the future
are equal to the spot rates in effect for that date. Again, in practice, the theory fails due to the
lack of adjustment for a risk premium. Therefore, the unbiased expectations really do not
occur in actual trading.
Because forward rates theoretically reflect all available information, they then become
unbiased predictors of futures spot rates.

Exchange Rate Models

1. Demand/Supply Approach: A country’s exchange rates with other countries will
move to ensure that the total demand for its currency equals the total supply of its
currency.
- Whenever someone sells a country’s domestic currency (for the UK the Pound) for
foreign currency (for the UK, Euros, Dollars etc) they create a demand for foreign
currency/a supply of domestic currency. Conversely if someone buys a country’s
domestic currency with foreign currency, they create a demand for domestic
currency/a supply of foreign currency.
- If the total demand for domestic currency/supply of foreign currency equals the total
supply of domestic currency/demand for foreign currency that country’s balance of
 payments is in balance. There is no reason for its exchange rates to rise or fall; its
exchange rates can stay constant.
- If a country’s balance of payments moves into deficit (the supply of domestic
currency exceeds the demand for domestic currency) its exchange rates will
fall/depreciate (reducing the price of domestic currency/increasing the price of foreign
currency) until the overall balance of payments is in balance again.
- If a country’s balance of payments moves into surplus (demand for domestic currency
exceeds the supply of domestic currency) its exchange rates will rise/appreciate until
overall balance in its balance of payments is restored.

2. Monetary Approach
The monetary model assumes a simple money demand curve. The purchasing power parity or
the law of one price holds true. The monetary model also assumes a vertical aggregate money
supply curve.
According to the absolute purchasing power parity the exchange rate is obtained by dividing
the price level of the home country with that of the foreign country.i.e. P = e x P*, 
P stands for the domestic price level and P* the foreign price level. e is the exchange rate.

The demand for money equation is given by 

Md = kPy
Where k is constant and y is the real income level

In equilibrium, The demand for money, Md =Ms , the supply of money

Hence at the point of intersection of the aggregate demand and the aggregate supply curve,

kPy=Ms
or, P = Ms / ky
or eP* = P = Ms / ky
or, e = Ms / P*ky

At this point external equilibrium is obtained in the economy. It is also clear from the above
equation that an increase in the money supply within an economy would lead to appreciation
of the domestic currency. Conversely, international price level as well as the output level
related inversely with the exchange rate.

3. Portfolio Balance Approach: The portfolio balance approach is an extension of the

monetary exchange rate models focusing on the impact of bonds. According to this
approach, any change in the economic conditions of a country will have a direct
impact on the demand and supply for the domestic and the foreign bond. This shift in
the demand/supply for bonds will in turn influence the exchange rate between the
domestic and foreign economies.
The key advantage of the portfolio approach when compared to traditional approaches is that
the financial assets tend to adjust considerably faster to news economic conditions than
tradeable goods. Nevertheless, based on empirical evidence, the portfolio balance approach is
not an accurate predictor of exchange rates.

UNIT 3
Standard No. 8
U.S. accounting standard that requires US firms to translate their foreign affiliates' accounts
by the temporal method; that is, reporting gains and losses from currency fluctuations in
current income. It was in effect between 1975 and 1981 and became the most controversial
accounting standard in the US. It was replaced by FASB No. 52 in 1981.
Standard No. 52
The US accounting standard that replaced FASB No. 8. US companies are required to
translate foreign accounts in terms of the current rate and report the changes
from currency fluctuations in a cumulative translation adjustment account in
the equity section of the balance sheet.

Transaction Exposure: Defined as the sensitivity of “realized” domestic currency values of

the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange
rate changes. Transaction exposure arises from fixed-price contracting in a world of
constantly changing exchange rates. Management of this exposure can be done via:
1. Forward Market Hedge: If you owe forex in future, agree to buy forex now by
entering into long forward contract. (receive – sell - short)
2. Money Market Hedge: To hedge forex, buy forex and sit on it. Invest that amount at
foreign rate.
3. Options Market Hedge: Provide flexible hedge against downside, while preserving the
upside potential.
- To hedge foreign currency payable, buy calls on the currency. (If currency
appreciates, your call option lets you buy the currency at the initial low strike price)
- To hedge foreign currency receivable, buy puts on the currency (If currency
depreciate, your put option lets you sell the currency at the initial higher strike price)
4. Cross Hedging – Hedging a position in one asset by taking a position in another asset.
Translation Exposure: Exchange rate risk as applied to the firm’s consolidated financial
statements. Consolidation involves translation of subsidiaries’ financial statements from local
currencies to home currency. Involves many controversial issues.
1. Current/Noncurrent Method: Current assets at spot, non-current at historic rate.
2. Monetary/Nonmonetary Method: Monetary accounts at spot, non-monetary at historic
3. Temporal Method: Items carried at their current value – current rate, items carried at
historical costs – historic rate
4. Current Rate Method: All items translated at current rate; a plug equity account
named cumulative translation adjustment balances the B/S
Economic Exposure (LQP): Economic exposure can be defined as the extent to which the
value of the firm would be affected by unanticipated changes in exchange rates. It is the
sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s
operating cash flow to random changes in exchange rates.
It has two components, both of which effect the firm value:
- Asset Exposure: Effect of exchange rate fluctuations in home currency value of assets
and liabilities
- Operating Exposure: Effect of exchange rate fluctuations in future operating cash
flows
Measuring Economic Exposure
1. If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on
the dollar pound exchange rate, S ($/£), the regression would be of the form:
P = a + b×S + e
a- Regression constant
e - Random effort term with mean zero
 b – regression coefficient b measures the sensitivity of the dollar value of the assets
(P) to the exchange rate S

b = Cov (P,S)/Var (S)

There are two sources of economic exposure, i.e. the variance of exchange rate and the
covariance between the dollar value of the asset and exchange rate.

Operational Exposure: The effect of random changes in exchange rates on the firm’s
competitive position, which is not readily measurable. A good definition of operating
exposure is the extent to which the firm’s operating cash flows are affected by the exchange
rate. It has two components, the competitive effect (difficulties and increased costs of
shipping) and the conversion effect (lower dollar prices of imports due to foreign currency
and exchange rate depreciation). Operating exposure can be managed by:
- Selecting low cost production sites (Honda built north American factories due to
strong yen, later found itself importing more cars from Japan due to weak yen)
- Flexible sourcing policy (applies to workers as well)
- Diversification of the market (diversifying exchange rate risk)
- R&D & Product Differentiation (leads to less elastic demand)
-
Multi National Financial System
Financial transactions within the MNC result from internal transfer of goods, services,
technology and capital. These flows emerge from intermediate and finished goods to fewer
tangible items such as management skills and patents. Those transactions not liquidated
immediately give rise to some type of financial claim, such as royalties for the use of patent.
This forms a multinational financial system which can be broadly characterised by the
following factors:
1. Mode of Transfer: The MNC has considerable freedom in selecting the financial
channels through which funds, allocated profits or both are moved Moreover, the
MNC can move profits and cash from one unit to another by adjusting transfer prices
on inter-company sale-purchase of goods and services
2. Timing Flexibility: Some of the internally generated financial claims require a fixed
payment schedule, while others can be accelerated or delayed. This leading & lagging
is applied to inter-affiliate trade credit where a change in account terms can involve
massive shifts in liquidity.
3. Value: Value of MNC’s network of financial linkages stems from wide variations in
national tax systems and significant costs and barriers associated with international
financial transfer. These can be classified as the following arbitrage opportunities:
- Tax Arbitrage: Shifting profits from units located in high tax nations to those in low
tax nations.
- Financial Market Arbitrage: This can be done by transferring funds amongst units.
Firms can earn higher risk adjusted yields on excess funds, reduce risk adjusted cost
of borrowed funds, and tap previously unavailable capital resources.
- Regulatory System Arbitrage: When subsidiary profits are a function of government
regulations, or union pressure rather than marketplace, the ability to disguise true
profitability by reallocating profits can give the MNC negotiating advantage.

Inter-Company Fund Flow Mechanism

There are different channels available to the multinational enterprise, for moving money and
profits internationally. These include transfer pricing, royalty adjustments, leading and
lagging etc. There are certain costs, benefits and constrained associated with each of these
methods of effecting inter-company funds flow.
1. Tax Factors: Total tax payment on intercompany fund depend on tax regulations of
both the host and recipient nation. Host country has two types of taxes: corporate
income tax and withholding tax. Germany & Japan tax retained earnings at a usually
higher rate. As an offset to additional taxes, most countries provide tax credits for
affiliate taxes already paid on the same income.
2. Transfer Pricing: It is the pricing of goods and services traded internally. Each
government normally presumes that multinationals use transfer pricing to its country’s
detriment. The most important use of transfer pricing includes, reducing taxes,
reducing tariffs and avoiding exchange controls. It can also be used to increase the
MNC’s share of profits from a Joint venture and to disguise an affiliate’s true
profitability.
3. Fees & Royalties: Management services such as headquarter advice, allocated
overheads, patents and trademarks are often unique, without a reference market price.
The difficulty in pricing these resources makes them suitable for use as additional
routes for international fund flows by varying the fees and royalties charged for using
these intangible factors of production.
4. Leading & Lagging: It’s a highly favoured means of shifting liquidity among
affiliates in an acceleration (leading) or delay (lagging) in the payment of inter-
affiliate accounts by modifying the credit terms extended by one unit to another.
For example, suppose A sells goods worth $1 million monthly to B (affiliate) on 90-day
credit terms. Then on average, A has $3 million accounts receivables from B, and is in
effect financing $3 million of working capital for affiliate B. If the terms are changed
to 180 days, this will create a flow of $6 million to B. Reducing credit terms to 30
days will create a flow of $2 million from B to A.

The value of leading and lagging depends on the opportunity cost of funds to both the paying
unit and the recipient.
- When an affiliate already in surplus position receives payment, it can invest the
additional funds at the prevailing local lending rate. If it requires working capital, the
payment received can be used to reduce its borrowings at the borrowing rate.
- If a paying unit has excess funds, it loses cash that it would have invested at the
lending rate. If it’s in a deficit position, it has to borrow at the borrowing rate.
Assessment of the benefits of shifting liquidity among affiliates require that these
borrowing and lending rates be calculated on an after-tax dollar basis.

Designing Global Remittance Policy

The task facing international financial executives is to coordinate the use of various financial
linkages in a manner which maximizes the value for the firm as a whole. This task requires
answering 4 inter-related decisions:
1. How much money to remit
2. When to do so
3. Where to transmit these funds
4. Which transfer methods to use
To take advantage of its internal financial system, the firm must conduct a comprehensive
analysis of the available remittance options and their associated costs and benefits. It must
also compare the value of deploying funds in affiliates other than just remitting subsidiary
and the parent.
Most multinationals however make their dividend remittance decision independently of say,
their royalty of leading/lagging decision rather than considering the mix of transfer
mechanism that would be best for the company overall. This decision to satisfice rather than
optimize is due to complex nature of the financial linkages in a typical multinational
corporation.

GDR: A global depositary receipt (GDR) is very similar to an American depositary receipt
(ADR). It is a type of bank certificate that represents shares in a foreign company, such that a
foreign branch of an international bank then holds the shares. The shares themselves trade as
domestic shares, but, globally, various bank branches offer the shares for sale. Private
markets use GDRs to raise capital denominated in either U.S. dollars or euros. When private
markets attempt to obtain euros instead of U.S. dollars, GDRs are referred to as EDRs.

ADR (LQP): An American depositary receipt (ADR) is a negotiable certificate issued by a

U.S. depository bank representing a specified number of shares—or as little as one share—
investment in a foreign company's stock. The ADR trades on markets in the U.S. as any stock
would trade. ADRs represent a feasible, liquid way for U.S. investors to purchase stock in
companies abroad. Foreign firms also benefit from ADRs, as they make it easier to attract
American investors and capital—without the hassle and expense of listing themselves on U.S.
stock exchanges. The certificates also provide access to foreign listed companies that would
not be open to U.S. investment otherwise.

Euro Bond (LQP): A Eurobond is denominated in a currency other than the home currency
of the country or market in which it is issued. These bonds are frequently grouped together by
the currency in which they are denominated, such as Eurodollar or euro yen bonds. Issuance
is usually handled by an international syndicate of financial institutions on behalf of the
borrower, one of which may underwrite the bond, thus guaranteeing purchase of the entire
issue. The popularity of Eurobonds as a financing tool reflects their high degree of flexibility
as they offer issuers the ability to choose the country of issuance based on the regulatory
market, interest rates and depth of the market. They are also attractive to investors because
they usually have small par values and high liquidity.

Foreign Bond: A foreign bond is a bond issued in a domestic market by a foreign entity in
the domestic market's currency as a means of raising capital. For foreign firms doing a large
amount of business in the domestic market, issuing foreign bonds, such as bulldog bonds,
Matilda bonds and samurai bonds, is a common practice. Since investors in foreign bonds are
usually the residents of the domestic country, investors find the bonds attractive because they
can add foreign content to their portfolios without the added exchange rate exposure.

UNIT 4
International Portfolio Investment (IPM) (LQP – International Portfolio Diversification)
International Portfolio Investment is the investment by individuals and institutional investors
in international stocks, bond and other securities. Rapid growth in IPM, reflects globalisation
of financial markets accruing to governmental efforts around the globe to deregulate foreign
exchange.
International diversification is important because security returns are substantially less
correlated across countries than within a country, because of varying economic, political,
psychological factors. The diversification benefits are thereby achieved through the addition
of low correlation assets that serve to reduce the overall risk of the portfolio. Apart from
benefits, there are certain risks that international investors face:
 1. Higher Transaction Costs: Despite globalization, transaction costs can vary greatly
depending on which foreign market you invest in. Brokerage commission are higher
in international markets. On top of that, stamp duties, taxes, clearing fees and
exchange fees can depreciate your returns.
Solutions: These costs can be countered using ADR, that trade on local exchanges and can be
bought with same transaction costs, they are denominated in dollar yet are exposed to
fluctuations in exchange rate.
2. Currency Volatility: Investment in foreign market requires exchanging your domestic
currency (say USD) for foreign currency. If you hold the asset for a year, and sell it,
you still will have to convert the foreign currency back to USD at prevailing rate.
Uncertainty of what future exchange rate will be, scares many investors, and affects
your returns.
Solution: Hedging Transaction Exposure as described in Unit 3.
3. Liquidity Risks: Risk of not being able to sell your stock quickly enough once a sell
order is entered into. Thereby caution must be exercised, else foreign investments can
become illiquid by the time the investor closes her position.
Solution: Illiquid assets have wider assets. Narrower spreads and high volume suggest higher
liquidity.

International Bond Investment: As the business world becomes more globalized,

companies now have ways to access cheaper sources of funds and financing outside of their
country of operations. Instead of relying on investors in the domestic markets, businesses and
governments can tap into the pockets of global investors for much needed capital. One way
through which companies can access the international lending scene is by issuing
international bonds.
An international bond is issued in a country or currency that is not domestic to the investor.
From the perspective of a domestic investor and resident of the United States, an international
bond is one that is issued by corporations or governments in other countries denominated in a
currency other than the U.S. dollar. These bonds are issued outside of the United States and
are generally backed by the currency of the native country. International bonds include
Eurobonds, foreign bonds, and global bonds.

Optimal International Asset allocation (LQP): Rational investors would select portfolio by
considering returns as well as risk. They may be willing to assume additional risk if they are
sufficiently compensated by a higher expected return. The world beta measures the
sensitivity of the national market to the world market movements. National stock market
returns performance can be measured by Sharpe Performance Measure (SHP) that represents
the excess return per standard deviation risk.

SHP (i) = (Ri (bar) – Rf)/Sigma (i)

Where Ri (bar) & sigma (i) are the mean and standard deviation of returns, Rf is the risk-free
interest rate
Investors allocate the largest share of the funds, to the nation having the highest Sharpe Ratio.

Delta (SHP) = SHP (OIP) – SHP (DP)

OIP - Optimal International Portfolio, DP – Domestic Portfolio
Delta (SHP) represents the extra return per standard deviation of risk accruing from inter-
national investment. Moreover, this extra return can be measured by multiplying Delta (SHP
with the standard deviation of the domestic portfolio.
Delta (R) = (Delta SHP) (Sigma DP)
International Project Appraisal
(Very briefly covered here, for in-depth understanding refer to Ch-17 PPT of Eun & Resnick:
bit.ly/ifcap17)
How to undertake International Capital Budgeting:
Estimate future cash flows in foreign currency.
Convert to U.S. dollars at the predicted exchange rate.
Calculate APV using the U.S. cost of capital.

IRR Method
The internal rate of return (IRR) is a metric used in capital budgeting to estimate the
profitability of potential investments. The internal rate of return is a discount rate that makes
the net present value (NPV) of all cash flows from a particular project equal to zero. IRR
calculations rely on the same formula as NPV does.
NPV=[∑Ct/(1+r) ^t] − C0 = 0
Ct=net cash inflow during the period t
C0=total initial investment costs
r=the discount rate that is IRR (higher the better)
t=the number of time periods

APV Method
Adjusted present value (APV), defined as the net present value of a project if financed solely
by equity plus the present value of financing benefits. It is very similar to NPV. The
difference is that is uses the cost of equity as the discount rate rather than WACC. And APV
includes tax shields such as those provided by deductible interests. APV analysis is effective
for highly leveraged transactions.

NPV (of a venture financed solely with equity capital) + PV of financing

If: Investment = $500,000, Cash flow from equity = $25,000, Cost of equity = 20%, Cost of,
Debt = 7%, Interest on debt = 7%, Tax = 35%, Finance the deal half with equity and half with
debt

NPV = -$500,000 + ($25,000 / 20%) = -$375,000

PV = (35% x $250,000 x 7%) / 7% = $87,500

-$375,000 + $87,500 = -$287,500 –> Bad Deal

Country Risk Analysis (LQP): Country Risk refers to the uncertainty associated with
investing in a particular country, and the degree to which that uncertainty can lead to losses
for investors. This can come from any number of factors including political, economic,
exchange-rate etc.
- Country risk (in-general) denotes the risk that a foreign government will default on its
bonds or other financial commitments.
- In a broader sense, country risk is the degree to which political and economic unrest
affect the securities of issuers doing business in a particular country.
- Country risk is critical to consider when investing in less-developed nations. To the
degree that factors such as political instability can affect the investments in a given
country, these risks are elevated because of the great turmoil that can be created in
financial markets.
 - Most investors think of the United States as the benchmark for low country risk. So, if
an investor is attracted to investments in countries with high levels of civil conflict,
like Argentina or Venezuela for instance, he or she would be wise to compare their
country risk to that of the U.S.

Political Risk (LQP): Political risk is the risk an investment's returns could suffer as a result
of political changes or instability in a country. Instability affecting investment returns could
stem from a change in government, legislative bodies, other foreign policy makers or military
control. Political risk is also known as "geopolitical risk," and becomes more of a factor as
the time horizon of an investment gets longer. Political risks are notoriously hard to quantify
because there are limited sample sizes or case studies when discussing an individual nation.
Some political risks can be insured against through international agencies or other
government bodies. The outcome of a political risk could drag down investment returns or
even go so far as to remove the ability to withdraw capital from an investment.

Below are the types of political risks:

1. Expropriation*/Government Interference: For no apparent reason or with no
justification, foreign governments can seize, confiscate or otherwise expropriate a
company’s investment. They can even adopt a series of measures that have the effect
of expropriation.
*Expropriation: The action by the state or an authority of taking property from its owner for
public use or benefit.
2. Transfer & Conversion: During an economic crisis, foreign governments or central
banks may decide to impose restrictions or prohibitions on the conversion of the local
currency to hard currency or may prevent hard currency from leaving the country.
3. Political Violence: Political terrorism, war, civil strife or other forms of political
violence can damage or destroy a company’s assets and prevent it from conducting
operations essential to doing business.

Managing Political Risk:

- Consider diversifying your overseas investment, so all risks are not concentrated in
just one or two emerging markets
- Involve your key external stakeholders (customers, suppliers, agents) in political risk
migration by briefing them of your contingency plans for dealing with unexpected
political risk.
- Consider political risk insurance, that can protect exporters and investors from
specific types of political risk
- Hedging your portfolio against these risks. (If you forecast issues arising in Japan,
then buy put options in Nikkei 225, thus you can gain if Japanese stocks fall in value)

Multinational Working Capital Management

Current Asset Management for MNC
Although the fundamental principles governing the managing of working capital such as
optimization and suitability are almost the same in both domestic and multinational
enterprises, the two differ in respect of the following: MNCs, in managing their working
capital, encounter with a number of risks peculiar to sourcing and investing of funds, such as
the exchange rate risk and the political risk.
- Unlike domestic firms, MNCs have wider options of procuring funds for satisfying
their requirements or the requirements of their subsidiaries such as financing of
subsidiaries by the parent, borrowings from local sources etc.
 - MNCs enjoy greater latitude than the domestic firms in regard to their capability to
move their funds between different subsidiaries, leading to fuller utilization of the
resources.
- MNCs face a number of problems in managing working capital of their subsidiaries
because they are widely separated geographically and the management is not very
well acquainted with the actual financial state of affairs of the affiliates
- Finance managers of MNCs face problems in taking financing decision because of
different taxation systems and tax rates.

International Cash Management (LQP -Leading, Lagging)

Cash Management in an MNC is primarily aimed at minimizing the overall cash
requirements of the firm as a whole without adversely affecting the smooth functioning of the
company and each affiliate, minimizing the currency exposure risk, minimizing political risk,
minimizing the transaction costs and taking full advantage of the economies of scale and also
to avail of the benefit of superior knowledge of market forces
(For instance, minimization of the political risk involves conversion of all receipts in foreign
currencies in the currency of the home country. This may, however, go against the interest of
the affiliates who need minimum working capital to be kept in the local currencies to meet
their operational requirements)

Netting: A multinational firm should not consider deals in isolation, but should focus on
hedging the firm as a portfolio of currency positions. Many multinational firms use a
reinvoice center. Which is a financial subsidiary that nets out the intrafirm transactions. Once
the residual exposure is determined, then the firm implements hedging.

Pooling: The cash pooling (or cash pooling) is a centralized cash management strategy to
balance the accounts of a group’s subsidiaries. The final goal is to optimize the condition and
the management of the treasury by overcoming the imperfections of the financial markets
with less financial costs. The centralizing account of the holding is a unique account designed
to centralize every day all the account balances of the company’s subsidiaries and centralizes
the cash flow of the various accounts to improve the global management. This can be done by
transferring funds to accounts with negative balance, so that there is no higher interest
expense or transferring funds to one account, in order to reap the dividends of the credit
balance

Leading & Lagging: explained previously

Multinational Receivables Management (brief)
Basic considerations influencing credit and collection policies of MNCs are the same as those
of domestic firms. However, certain additional variables such as currency fluctuations,
exchange restrictions, differential inflation rates, etc have also to be reckoned with by an
MNC while managing receivables.
- Trade Credit is extended in anticipation of profit by expanded sales volume or
retaining customers
- Credit terms should consider sales force and adjusting bonuses for cost of credit sales

Multinational Inventory Management

Fundamental decision rules determining the optimal level of stock of raw materials and
components, work-in-process and finished goods are the same for both MNCs and domestic
firms. Even the techniques employed to determine the level of required, safety stocks are also
the same in both the cases. However, MNCs have to face certain additional problems in
managing inventories. These problems are the diverse inventories maintained in several
widely separated locations, frequently changing import controls and tariffs, and supply
disruptions due to strikes and political turmoil. Above all, currency fluctuation risk
complicates the task of inventory management in an international firm.

Extra
Home Bias: Home bias is the tendency for investors to invest in a large number of domestic
equities, despite the purported benefits of diversifying into foreign equities. This bias is
believed to have arisen as a result of the extra difficulties associated with investing in foreign
equities, such as legal restrictions and additional transaction costs. Other investors may
simply exhibit home bias due to a preference for investing in what they are already familiar
with rather than moving into the unknown.

Hedge Ratio: The hedge ratio compares the value of a position protected through the use of a
hedge with the size of the entire position itself. A hedge ratio may also be a comparison of
the value of futures contracts purchased or sold to the value of the cash commodity being
hedged. Futures contracts are essentially investment vehicles that let the investor lock in a
price for a physical asset at some point in the future.

Note: The fundamental here is to gain a short brief explanation of each topic from
examination point of view. In depth knowledge lies in books, please do refer to them as well.
(Eun-Resnick, Shapiro, PPT’s and other resources all available on bit.ly/NOTES-COUNCIL)