International Finance

INTRODUCTION

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 Introduction
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It is the branch of economics which deals with the dynamics

of:
 International Trade
 Exchange rate
 Foreign Investment
 Global financial system

It is a branch of International Economics

It is concerned with understanding all the procedures,

techniques & tools related to helping firm in accessing
global markets for short/long term funds.

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 Importance Of Studying International Finance
3

Can help a financial manager understand how

international events will affect a firm and what steps
can be taken to exploit positive developments and
insulate the firm from harmful ones.
Events like
 Changes in exchange rates
 Changes in the prices of oil and gold
 Election results
 The outbreak of war, or the establishment of peace etc.
have effects that instantly reverberate around the
Earth.
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 International Finance Vs Domestic Finance
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Exposure to Foreign Exchange

Macro Business Environment of different countries
Legal and Tax Environment
Different group of Stakeholders
Knowledge of Foreign Exchange Derivatives
Different Standards of Reporting
Capital Management skills
High risks
 What is International Trade??
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International trade is a cross border trade.

It refers to exchange of capital, goods, services etc. across

international borders or territories.

Without international trade, nations would be limited to

the goods and services produced within their own borders.

Each country has scarce resources / specific skills – better

to produce some, rather than all.

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 Reasons for the growth of International Trade
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 A liberalization of trade and investment via reductions in

tariffs, quotas, currency controls, and other restrictions to the
international flow of goods and capital.
 Rapid improvements in communication technologies and
transportation , and consequent reductions in costs.
 This has resulted in a globalization of markets and consequent
rapid growth in international trade.

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 Multi National Company (MNC)
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 A MNC is an enterprise which has its managerial

H Q located in one country & operations in a number of
countries.

 They expand either by setting up branches abroad , JV,

subsidiaries etc.

 Expansion takes place through vertical / horizontal /

conglomerate route.

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 Significance of MNC’s
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 More than 35000 MNCs.

 Largest 100 of these possibly being responsible for

approximately 16 percent of the world's assets.

 1/3 rd of world production is controlled by MNC’s.

 The total sales of MNC will be 40% of world sales.

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 M N C- Features
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They
 think global, plan global, act global.

The
 plant size, operations, activities, place are global.

The
 MNC’s F M differs from Domestic FM in many ways.

Seeking capital at low cost markets on international basis

Investment proposals are decided on global basis.

Integrate their world wide operations

Flexiblein planning, adaptability to the environment, quickness in

decisions , innovative , selecting best talent , well developed R & D etc

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 Relevance of IF to India
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 I F has assumed significance after liberalization

 More & more FDI’s, FII’s & F F I’s are in Indian market

 Many Indian corporate are listed in foreign stock exchanges.

 Indian exports are growing at a rate of 12% per annum with 50% of
manufacturing items being exported.

 FDI & NRI continue to grow even in the recession years though there
may be a negative situation at times.

 Many international companies look to India for their market.

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 Relevance of IF to India
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 With such a scenario and the future though tense is bright too , it is
essential for the Finance managers to have fairly good knowledge on
International financial management.

 The company’s operations today are global & the finance manager has
to be well aware of the various intricacies on export/ import/ forex
front.

 The institutions operating in the international financial system are

closely connected with the foreign sectors of various economies.

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 Exchange Rate Systems
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 Evolution Of Money
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Barter system
Commodity Money Phase
 Valuable objects were used as a medium of exchange
Representative Money Phase
 Coins or notes backed by valuable metals such as gold or silver
Fiat Money Phase
 Paper currencies not backed by any valuable commodity but
only faith in the government issuing the currency.

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 The Gold Standard(1870-1936)
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Oldest exchange rate system

Used gold as the base for determining the value of money
Different versions of gold standard
 Gold Specie standard
 Bank notes where exchange for gold coins on demand
 Gold Bullion standard
 No compulsion to maintain gold coinage and for conversion gold bars
were purchased at fixed rates
 Gold Exchange standard
 Currency is linked to the currency of the country on gold standard.
 Convertibility existed but not directly
 Pegged currency was kept as reserve

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 Features Of The Gold Standard
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 Guaranteed two way convertibility

 Export and import of gold was allowed so that it could flow
freely among the gold standard countries
 The central bank held gold reserves in direct relationship with
the currency it had issued.
 The exchange rates depend upon the content of gold in
different currencies
 Money supply was constant, in view of constant gold reserves
and with constant money supply, prices were constant.
 Any deviation could occur only after discovery of new gold
mines.

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 Suspension Of Gold Standard
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 First world war broke out in 1914

 The warring nations increased the money supply and had to
suspend convertibility of currency into gold
 Countries deviated from the norms of the gold standard
 After the first world war countries returned to gold standard
 But it was not successful as most currencies where overvalued
and were having hyperinflation in the countries.

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 End Of Gold Standard
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 Many countries like UK to whose currency many countries

pegged their currency, were not having sufficient gold stock
and could not meet the demand of conversion of currency into
gold by countries like France.
 The great depression of 193o worsened the situation and led to
the collapse of gold standard regime in 1936 and leading to a
system of floating exchange rates and this situation continued
till the end of the World War II.

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 Bretton Woods System Of Exchange Rates
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 At the conference at Bretton Woods, New Hampshire, USA,

IMF and WORLD BANK were established.
 Introduced Fixed Parity System
 Each member country was to set a fixed value-called the par
value-of its currency in terms of gold or the US dollar.
 US government fixed the par value of US dollar as US $35 per
ounce of gold 
 US government agreed to convert the US dollar freely into gold
at the fixed parity of US $35 per ounce of gold.

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 Bretton Woods System Of Exchange Rates –Contd..
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 Fixed parity system linked the value of currencies with the

fixed amount of gold/US dollars.
 The exchange rates between currencies would be the
determined on the basis of their par values.
 Minor fluctuations in exchange rates within a narrow band of
1% of above or below the central parity was permissible
 Fluctuations beyond +/-1% had to be corrected by the
monetary authorities of the country through market
intervention
 US dollar was an intervention currency as it was directly
convertible into gold. Other currencies were convertible into
gold through US dollars.

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 Why US dollar was given the position of
intervention currency replacing British pounds??

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 Bretton Woods System Of Exchange Rates –Contd..
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Collapse of Fixed Parity System

 Fixed parity system failed to consider fast growing activities of
the MNCs which caused large flow of funds among different
countries that necessitated changes in exchange rates
 The system worked well till the beginning of 1960s.

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 Bretton Woods System Of Exchange Rates –Contd..
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Collapse of Fixed Parity System -Contd..

Confidence in the US dollar was reduced due to
 Deficit balance of payment
 Plummeting gold holdings in the US treasury.
 Budgetary deficit by financing Vietnam war.
 Overvalued position of US dollar.
Loss of confidence on US dollar which resulted in the
conversion of US dollar into gold by European
countries.

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 Bretton Woods System Of Exchange Rates –Contd..
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Collapse of Fixed Parity System -Contd..

The gold conversion of US treasury was on doubt
which resulted in massive selling of dollar.
Suspecting a possible collapse of dollar, Nixon
government suspended convertibility of dollar into
gold on August 15,1971, thus giving end to the Fixed
Parity System.

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 Smithsonian Arrangement
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Conference held at Smithsonian Institute,

Washington DC in 1971 to take actions to restore the
stability of the system.
Actions were
 Gold parity of US dollar was changed to $38 per ounce of gold.
(devaluation of 8.57%)
 Currencies of surplus countries like Canada and Japan were
revalued upward by 7.4% and 16.9% respectively.
 Band for fluctuation was widened to +/- 2.25% to enable
member countries to manage their exchange rates and
monetary policies.

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 Smithsonian Arrangement -Contd..
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Convertibility of US dollar was not guaranteed.

Massive flow of capital to strong currency countries
like Germany, France and Japan happened.
US govt. devalued the dollar (10%) to $42.22 per
ounce of gold in Feb 1973.
Still the flow happened and exchange market was
closed in March 1973 to avert the crisis and Fixed
Exchange rate system came to an end.

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 Jamaica Agreement-1976
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Broad options under new regime:-

Floating-Independent and Managed
Pegging of Currency
 to a single currency
 to a basket of currencies
 to SDRs
 Crawling peg
Target zone arrangement

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 Current Exchange Rate Regime
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Exchange rate arrangements on the basis of their

degree of flexibility 
1. Exchange arrangements with no separate legal tender
2. Currency board arrangements
3. Conventional fixed peg arrangements
4. Pegged exchange rates within horizontal bands
5. Crawling pegs
6. Exchange rates within crawling bands
7. Managed floating with no predetermined path for the
exchange rate
8. Independently floating

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 Current Exchange Rate Regime -Contd..
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1.Exchange arrangements with no separate legal

tender
 The currency of another country circulates as the sole legal
tender or the member belongs to a monetary or currency union
in which the same legal tender is shared by the members of the
union.
 Adopting such regimes implies the complete surrender of the
monetary authorities' control over domestic monetary policy.

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 Current Exchange Rate Regime -Contd..
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2.Currency Board arrangements

 A monetary regime based on an explicit legislative
commitment to exchange domestic currency for a specified
foreign currency at a fixed exchange rate.
 This implies that domestic currency will be issued only against
foreign exchange and that it remains fully backed by foreign
assets, leaving little scope for discretionary monetary policy.

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 Current Exchange Rate Regime -Contd..
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3.Conventional Fixed peg arrangements

 The country pegs its currency within margins of ±1 percent or
less vis-à-vis another currency or a basket of currencies, where
the basket is formed from the currencies of major trading or
financial partners.
4.Pegged exchange rates within horizontal bands
 The value of the currency is maintained within certain margins
of fluctuation of more than ±1 percent around a fixed
central. As in the case of conventional fixed pegs, reference
may be made to a single currency or a currency composite.

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 Current Exchange Rate Regime -Contd..
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5.Crawling pegs
 Under this system, a country pegs its currency to the currency
of another country, but allows the parity value to change
gradually over time ±1% to catch up with the changes in
market-determined rates.
 It is a hybrid of fixed and flexible-rate system.
6. Exchange rates within crawling bands
 The currency is maintained within certain fluctuation margins
of at least ±1 percent around a central and the central rate or
margins are adjusted periodically as per the market influences.

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 Current Exchange Rate Regime -Contd..
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7.Managed floating with no predetermined path for

the exchange rate
 The monetary authority attempts to influence the exchange
rate without having a specific exchange rate path or target.
 Intervention may be direct or indirect.
8.Independently floating
 The exchange rate is market-determined, without any official
foreign exchange market intervention aimed at preventing
undue fluctuations in the exchange rate.
 Macroeconomic factors determine the exchange rates.

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Balance of Payments
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 Balance of Payments
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B.Balance of Payments
The account is primarily to report the country' s
international performance in trading with other
nations, and to maintain a record of capital flowing
into and out of the country.
Record the flow of payments between the residents
of a country and the rest of the world during a given
time period.

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 Balance of Payments –Contd..
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Based on double entry system of accounting.

A transaction that results in a receipt from abroad is
credit transaction and payment to foreigners is debit
transaction.

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 Balance of Payments –Contd..
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Different ways a country gets Foreign Currency

 From Export of goods
 From Service such as transportation, insurance etc. provided
to foreigners
 Income from investments abroad
 Gifts from foreign residents
 Aid from foreign residents and governments
 Borrowings from other countries
 Sale of assets to foreign residents
 Investment in the country by foreign residents

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 B. Balance of Payments –Contd..
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Different ways a country loses Foreign Currency

 Import of goods
 Services received from foreign residents
 Income payable on investment made by foreigners in the
country
 Gifts to foreign residents
 Aid provided to foreign residents or governments
 Lending to foreigners
 Purchase of assets from foreign residents
 Investments made in other countries
 Repayment of borrowings from abroad

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 Balance of Payments –Contd..
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BOP is a statement that shows the different receipts

and payments made on different kinds of
transactions for a specific period.
BOP is divided into 5 major components:-
A. Current A/C.
B. Capital A/C
C. Errors and Omissions
D. Overall balance (Surplus or Deficit)
E. Monetary Movements
i. IMF transactions (SDR allocations)
ii. Official reserves movement

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 BOP- Current account
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A. Current Account Credits Debits Net

1.Merchandise
2.Invisibles (a+b+c)
a) Services
i)Travel Services
ii)Insurance services
iii)Transportation Services
iv)Govt. not included elsewhere

v)Miscellaneous
b) Unilateral Transfers
i)Official
ii)Private
c) Income
i)Investment Income
ii)Compensation to employees
Total Current Account (1+2)

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 BOP- Current account
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A.Current Account
 1.MERCHANDISE
 Merchandise trade cover all transactions that relate to movable
goods where change of ownership of physical goods happens
between residents of a country and non residents.
 The difference between the total of export and import is termed
balance of trade.
 Surplus= Export>Imports

 Deficit = Imports>Exports

 2. Invisibles
 Not tangible.

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 B.Balance of Payments –Contd..
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B. Capital account

 Sub-account of BOP.
 Shows inflow of capital into the country from abroad as well as
the outflows of capital to other foreign countries.

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 BOP- Capital account
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B. Capital Account Credits Debits Net

1.Foreign Investments
a)FDI
b)Portfolio Investments
2.Loans
a) External assistance
b) Commercial Borrowings(MT and LT)
c) Short term Credits

3)Holdings with Banks

a)Commercial Banks
b)Others

4.Other Capital

Total Capital Account (1 to 4)

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 Balance of Payments –Contd..
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Balance of trade
 Difference between receipts and payments in respect of Export and Import of
goods

Balance of Current account

 Difference between receipts and payments in respect of all Current a/c transactions

Balance of Capital account

 Difference between receipts and payments in respect of all Capital a/c transactions

Overall BOP
 Balance of Current Account + Balance of Capital a/c + statistical discrepancy

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 Balance of Payments –Contd..
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D. Overall Balance- Surplus and Deficit

 Surplus = Total Credits > Total Debits
 Deficit = Total Debits > Total Credits

E. Monetary Movements

 Deficit is adjusted by borrowings from IMF or through the
payment from FOREX reserves.
 Surplus increases FOREX reserves and is also used for
repaying earlier IMF borrowings.

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 Introduction to Foreign
Exchange Market
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 Foreign Exchange Market
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FOREX market does not refer to a location, rather it

refers to the process by which currencies of different
countries are exchanged.
Mostly an over-the-counter (OTC) market.
No centralized meeting point or physical market place.
Global market, not segregated into local or national
markets.
Market is dispersed over the whole world.
24 hour market, except on weekends.
Largest market in terms of volume of transactions.
High liquidity market.
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 Organization Of The Interbank Spot Market
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The largest part of trading, over 31 percent of the

global total, occurs in the United Kingdom.
Geographical distribution of average FOREX turnover
Country Percentage
turnover, share
billion US$
United 504 31.1
Kingdom
United 254 15.7
S tates
Japan 147 9.1
Singapore 101 6.2
Germany 88 5.4
Switzerland 71 4.4
Hong Kong 67 4.1
Australia 52 3.2
France 48 3.0
Other 286 17.8
Total 1618 100.0
Note

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 Organization Of The Interbank
48
Spot Market- Contd..

 The foreign exchange market is an informal arrangement of the

larger commercial banks and a number of foreign exchange brokers.

 The banks and brokers are linked together by telephone, telex, and

a satellite communications network called the Society for

Worldwide International Financial Telecommunications
(SWIFT).
 The banks and brokers are in almost constant contact, with activity

in some financial center or other 24 hours a day.

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 SWIFT
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 This computer based communications system, based in Brussels,

Belgium, links banks and brokers in every financial center.

 The SWIFT network, which has been available since 1977, has

grown so rapidly that it has virtually replaced the pre-existing

methods of conveying messages, namely the mail and telegraphic
transfer. SWIFT uses satellite linkages, and transmits messages
between banks in a standard format to minimize errors which can
easily occur due to different languages and banking customs.

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 Organization Of The Interbank
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Spot Market- Contd..

Size of transaction
 The standard-sized interbank trade is for $10 million (and the
equivalent in the foreign currency).
 However, trades may be a multiple of the standard trade or less
than the standard trade (although always more than $1
million).
FOREX Market Participants
A. Commercial Banks
a. Individuals
b. Business Firms
B. Brokers
C. Central Banks
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 Organization Of The Interbank
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Spot Market- Contd..

A. Commercial Banks

 In the case of interbank trading, banks trade directly with each

other, and all participating banks are market-makers. That
is, in the direct interbank market, banks quote buying and
selling prices to each other.
 The calling bank does not specify whether they wish to buy or
sell, or how much of the currency they wish to trade. Bank A
can call Bank B for a quote of ''their market'' or Bank B can call
Bank A.

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 Organization Of The Interbank
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Spot Market- Contd..

A. Commercial Banks -Contd..

 The direct market can be characterized as a decentralized,

continuous, open-bid, double-auction market.
 ''open'' because the buy/sell intention and amount are not
specified — it is left open — and ''double auction'' because
banks can call each other for price quotations.
 There is no central location of the market and price quotes are
a continuous process , ie. a quote of the bank's market to
another bank is good only for seconds.

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 Organization Of The Interbank
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Spot Market- Contd..

B. Foreign Exchange Brokers

 While the market-making banks take positions on their own
behalf and for customers, brokers deal for others, showing
callers their best rates, and charging a commission to buying
and selling banks.

 They are relatively few in numbers and place limit-orders.

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 Organization Of The Interbank
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Spot Market- Contd..

C. Central Banks

 Central banks enter the market when they want to regulate
exchange rates.
 In order to transact on their own behalf for FOREX reserves.
 They buy and sell on behalf of government for govt.
transactions

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 Foreign Exchange Market –Contd..
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Types of FOREX transactions

 Business transactions
 Hedging
 Arbitrage
 Speculations

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