nternational Financial Management is a well known term in todays world and it is also known as
international finance. It means financial management in an international business environment. It is
different because of different currency of different countries, dissimilar political situations, imperfect markets, diversified opportunity sets.
International Financial Management International Financial Management came into being when the countries of the world started opening their doors for each other. This phenomenon is well known with the name of liberalization. Due to the open environment and freedom to conduct business in any corner of the world, entrepreneurs started looking for opportunities even outside their country- boundaries. The spark of liberalization was further aired by swift progression in telecommunications and transportation technologies that too with increased accessibility and daily dropping prices. Apart from everything else, we cannot forget the contribution of financial innovations such as currency derivatives; cross border stock listings, multi-currency bonds and international mutual funds. The resultant of liberalization and technology advancement is todays dynamic international business environment. Financial management for a domestic business and an international business is as dramatically different as the opportunities in the two. The meaning and objective of financial management does not change in international financial management but the dimensions and dynamics changes drastically. Difference between International and Domestic Financial Management: Four major facets which differentiate international financial management from domestic financial management are introduction of foreign currency, political risk and market imperfections and enhanced opportunity set. Foreign Exchange: Its an additional risk which a finance manager is required to cater to under an International Financial Management setting. Foreign exchange risk refers to the risk of fluctuating prices of currency which has the potential to convert a profitable deal into a loss making one. Political Risks: Political risk may include any change in the economic environment of the country viz. Taxation Rules, Contract Act etc. It is pertaining to the government of a country which can anytime change the rules of the game in an unexpected manner. Market Imperfection: Having done a lot of integration in the world economy, it has got a lot of differences across the countries in terms of transportation cost, different tax rates, etc. Imperfect markets force a finance manager to strive for best opportunities across the countries. Enhanced Opportunity Set: By doing business in other than native countries, a business expands its chances of reaping fruits of different taste. Not only does it enhances the opportunity for the business but also diversifies the overall risk of a business. Just like domestic financial management, the goal of International Finance is also to maximize the shareholders wealth. The goal is not only is limited to the Shareholders but extends to all Stakeholders viz. employees, suppliers, customers etc. No goal can be achieved without achieving welfare of shareholders. In other words, maximizing shareholders wealth would mean maximizing the price of the share. Here again comes a question, whether in which currency should the value of the share be maximized? This is an important decision to be taken by the management of the organization. International level initiatives like General Agreement on Trade and Tariffs (GATT), The North American Free Trade Agreement (NAFTA), World Trade Organization (WHO) etc has give promoted international trade and given it a shape. All because of liberalization and those international agreements, we have a buzz word called MNC i.e. Multinational Corporations. MNCs enjoy an edge over other normal companies because of its international setting and best opportunities. International Finance has become an important wing for all big MNCs. Without the expertise in International Financial Management, it can be difficult to sustain in the market because international financial markets have a total different shape and analytics compared to the domestic financial markets. A sound management of international finances can help an organization achieve same efficiency and effectiveness in all markets
Forex Market Participants Consumers and Travelers Consumers may purchase goods in a foreign country or via the internet with their credit card. The amount consumers pay in the foreign currency will be converted to their home currency on their credit card statement. Travelers must go to a bank or currency exchange bureau to convert one currency (their "home" currency) into another (the "destination" currency) when using cash to pay for goods and services in a foreign country. Travelers need to be aware of exchange rates to ensure they receive a fair deal. Businesses Businesses often need to convert currencies when they conduct trade outside their home country. Large companies need to convert huge amounts of currency; a multinational company such as General Electric (GE) for instance, converts tens of billions of dollars each year. Investors and Speculators Investors and speculators require currency exchange whenever they deal in any foreign investment, be it equities, bonds, bank deposits, or real estate. Investors and speculators also trade currencies in an attempt to benefit from movements in the currency exchange markets. Commercial and Investment Banks Commercial and investment banks trade currencies as a service to their commercial banking, deposit, and lending customers. These institutions also participate in the currency market for hedging and speculative purposes. Governments and Central Banks Governments and central banks trade currencies to improve economic conditions or to intervene in an attempt to adjust economic or financial imbalances. Because they are non-profit, governments and central banks do not trade with the intention of earning a profit, but because they tend to trade on a long-term basis, it is not unusual for some trades to earn revenue.
FOREX MARKET PLAYERS Forex Market The Forex market is an international over-the-counter market (OTC). It means that it is a decentralized, self-regulated market with no central exchange or clearing house, unlike stocks and futures markets. This structure eliminates fees for exchange and clearing, thereby reducing transaction costs. The Forex OTC market is formed by different participants with varying needs and interests that trade directly with each other. These participants can be divided in two groups: the interbank market and the retail market. The Interbank Market The interbank market designates Forex transactions that occur between central banks, commercial banks and financial institutions. Central Banks - National central banks (such as the US Fed and the ECB) play an important role in the Forex market. As principal monetary authority, their role consists in achieving price stability and economic growth. To do so, they regulate the entire money supply in the economy by setting interest rates and reserve requirements. They also manage the country's foreign exchange reserves that they can use in order to influence market conditions and exchange rates. Commercial Banks - Commercial banks (such as Deutsche Bank and Barclays) provide liquidity to the Forex market due to the trading volume they handle every day. Some of this trading represents foreign currency conversions on behalf of customers' needs while some is carried out by the banks' proprietary trading desk for speculative purpose. Financial Institutions - Financial institutions such as money managers, investment funds, pension funds and brokerage companies trade foreign currencies as part of their obligations to seek the best investment opportunities for their clients. For example, a manager of an international equity portfolio will have to engage in currency trading in order to buy and sell foreign stocks. The Retail Market The retail market designates transactions made by smaller speculators and investors. These transactions are executed through Forex brokers who act as a mediator between the retail market and the interbank market. The participants of the retail market are hedge funds, corporations and individuals. Hedge Funds - Hedge funds are private investment funds that speculate in various assets classes using leverage. Macro Hedge Funds pursue trading opportunities in the Forex Market. They design and execute trades after conducting a macroeconomic analysis that reviews the challenges affecting a country and its currency. Due to their large amounts of liquidity and their aggressive strategies, they are a major contributor to the dynamic of Forex Market. Corporations - They represent the companies that are engaged in import/export activities with foreign counterparts. Their primary business requires them to purchase and sell foreign currencies in exchange for goods, exposing them to currency risks. Through the Forex market, they convert currencies and hedge themselves against future fluctuations. Individuals - Individual traders or investors trade Forex on their own capital in order to profit from speculation on future exchange rates. They mainly operate through Forex platforms that offer tight spreads, immediate execution and highly leveraged margin accounts.
Q.1 : Define Foreign Exchange and Explain the Functions of Foreign Exchange Market. (M.2011) Ans. A) FOREIGN EXCHANGE Foreign Exchange refers to foreign currencies possessed by a country for making payments to other countries. It may be defined as exchange of money or credit in one country for money or credit in another. It covers methods of payment, rules and regulations of payment and the institutions facilitating such payments. A. FOREIGN EXCHANGE MARKET A foreign exchange market refers to buying foreign currencies with domestic currencies and selling foreign currencies for domestic currencies. Thus it is a market in which the claims to foreign moneys are bought and sold for domestic currency. Exporters sell foreign currencies for domestic currencies and importers buy foreign currencies with domestic currencies. According to Ellsworth, "A Foreign Exchange Market comprises of all those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money". Foreign Exchange transactions result in inflow & outflow of foreign exchange. B. FUNCTIONS OF FOREIGN EXCHANGE MARKET Foreign exchange is also referred to as forex market. Participants are importers, exporters, tourists and investors, traders and speculators, commercial banks, brokers and central banks. Foreign bill of exchange, telegraphic transfer, bank draft, letter of credit etc. are the important foreign exchange instruments used in foreign exchange market to carry out its functions. The Foreign Exchange Market performs the following functions. 1. Transfer Of Purchasing Power I Clearing Function The basic function of the foreign exchange market is to facilitate the conversion of one currency into another i.e. payment between exporters and importers. For eg. Indian rupee is converted into U.S. dollar and vice-versa. In performing the transfer function variety of credit instruments are used such as telegraphic transfers, bank drafts and foreign bills. Telegraphic transfer is the quickest method of transferring the purchasing power. 2. Credit Function The foreign exchange market also provides credit to both national and international, to promote foreign trade. It is necessary as sometimes, the international payments get delayed for 60 days or 90 days. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required. For eg. Mr. A can get his bill discounted with a foreign exchange bank in New York and this bank will transfer the bill to its correspondent in India for collection of money from Mr. B after the stipulated time. 3. Hedging Function A third function of foreign exchange market is to hedge foreign exchange risks. By hedging, we mean covering of a foreign exchange risk arising out of the changes in exchange rates. Under this function the foreign exchange market tries to protect the interest of the persons dealing in the market from any unforseen changes in exchange rate. The exchange rates under free market can go up and down, this can either bring gains or losses to concerned parties. Hedging guards the interest of both exporters as well as importers, against any changes in exchange rate. Hedging can be done either by means of a spot exchange market or a forward exchange market involving a forward contract.
Q. 2 : Explain the dealers or participants in foreign exchange market. (M.2011) Ans. A) PARTICIPANTS I DEALERS IN FOREIGN EXCHANGE MARKET Foreign exchange market needs dealers to facilitate foreign exchange transactions. Bulk of foreign exchange transaction are dealt by Commercial banks & financial institutions. RBI has also allowed private authorised dealers to deal with foreign exchange transactions i.e buying & selling foreign currency. The main participants in foreign exchange markets are 1. Retail Clients Retail Clients deal through commercial banks and authorised agents. They comprise people, international investors, multinational corporations and others who need foreign exchange. 2. Commercial Banks Commercial banks carry out buy and sell orders from their retail clients and of their own account. They deal with other commercial banks and also through foreign exchange brokers. 3. Foreign Exchange Brokers Each foreign exchange market centre has some authorised brokers. Brokers act as intermediaries between buyers and sellers, mainly banks. Commercial banks prefer brokers.
4. Central Banks Under floating exchange rate central bank does not interfere in exchange market. Since 1973, most of the central banks intervened to buy and sell their currencies to influence the rate at which currencies are traded. From the above sources demand and supply generate which in turn helps to determine the foreign exchange rate. B. TYPES OF FOREIGN EXCHANGE MARKET Foreign Exchange Market is of two types retail and wholesale market. 1. Retail Market The retail market is a secondary price maker. Here travellers, tourists and people who are in need of foreign exchange for permitted small transactions, exchange one currency for another. 2. Wholesale Market The wholesale market is also called interbank market. The size of transactions in this market is very large. Dealers are highly professionals and are primary price makers. The main participants are Commercial banks, Business corporations and Central banks. Multinational banks are mainly responsible for determining exchange rate. 3. Other Participants a) Brokers Brokers have more information and better knowledge of market. They provide information to banks about the prices at which there are buyers and sellers of a pair of currencies. They act as middlemen between the price makers. b) Price Takers Price takers are those who buy foreign exchange which they require and sell what they earn at the price determined by primary price makers.
c) Indian Foreign Exchange Market It is made up of three tiers i. Here dealings take place between RBI and Authorised dealers (ADs) (mainly commercial banks). ii. Here dealings take place between ADs iii. Here ADs deal with their corporate customers. Q. 3 : Define I Explain I Write note on spot and forward exchange rates. Ans. A) EXCHANGE RATE Transactions in exchange market are carried out at what are termed as exchange rates. In foreign exchange market two types of exchange rate operations take place. They are spot exchange rate and forward exchange rate. 1) Spot Exchange Rate :- When foreign exchange is bought and sold for immediate delivery, it is called spot exchange. It refers to a day or two in which two currencies are involved. The basic principle of spot exchange rate is that it can be analysed like any other price with the help of demand and supply forces. The exchange rate of dollar is determined by intersection of demand for and supply of dollars in foreign exchange. The Remand for dollar is derived from countrys demand for imports which are paid in dollars and supply is derived from countrys exports which are sold in dollars. The exchange rate determined by market forces would change as these forces change in market. The primary price makers buy (Bid) or sell (ask) the currencies in the market and the rates continuously change in a free market depending on demand and supply. The primary dealer (bank) quotes two-way rates i.e., buy and sell rate. (Bid) Buy Rate 1 US $ = ` 45.50 (Ask) Sell Rate 1 US $ = ` 45.75 The bank is ready to buy 1 US $ at Rs. 45.50 and sell at Rs. 45,75. The difference of Rs.0.25 is the profit margin of dealer. 2) Forward Exchange Rate Here foreign exchange is bought or sold for future delivery i.e., for the period of 30, 60 or 90 days: There are transactions for 180 and 360 days also. Thus, forward market deals in contract for future delivery. The price for such transactions is fixed at the time of contract, it is called a forward rate. Forward exchange rate differs from spot exchange rate as the former may either be at a premium or discount. If the forward rate is above the present spot rate, the foreign exchange rate is said to be at a premium. If the forward rate is below the present spot rate, the foreign exchange rate is said to be at a discount. Thus foreign exchange rate may be at forward premium or at forward discount. For Eg. an Indian importer may enter into an agreement to purchase US $ 10,000 sixty days from today at 1 US $ = Rs. 48. No amount is paid at the time of agreement, except for usual security margin money of about 10% of the total amount. 60 days form today, the importer will get 10,000 US $ in exchange for Rs. 4,80,000 irrespective of the Spot exchange rate prevailing on that date. a) Factors Influencing Forward Exchange Rate i) Interest rates. ii) Degree of speculation in foreign exchange market. iii) Inflation rate. iv) Foreign investors confidence in domestic country. v) Economic situation in the country. vi) Political situation in the country. vii) Balance of payments position etc. b) Need For Forward Exchange Rate Contracts To overcome the possible risk of loss due to fluctuations in exchange rate, exporters, importers and investors in other countries may enter in forward exchange rate contracts. In floating or flexible exchange rate system the possibility of wide fluctuation in exchange is more. Thus, both exporters and importers safeguard their position through a forward arrangement. By entering into such an arrangement both parties minimize their loss.
Q. 4 : Write note on Arbitrage. O R Write note on Interest rate and Arbitrage. Ans. A. ARBITRAGE Arbitrage is the act of simultaneously buying a currency in one market and selling it in another to make a profit by taking advantage of exchange rate differences in two markets. If the arbitrages are confined to two markets only it is said two-point arbitrage. If they extend to three or more markets they are known as three-point or multi- point arbitrage. Those who deal with arbitrage are called arbitrageurs. A Spot sale of a currency when combined with a forward repurchase in a single transaction is called Currency Swap". The Swap rate is the difference between spot and forward exchange rates in currency swap. Arbitrage opportunities may exist in a foreign exchange market.. Suppose the rate of exchange is 1 US $ = `. 50 in US market and 1 US $ = `. 55 in Indian Markets, then an arbitrageur can buy dollars in US market and sell it in Indian market and get a profit of `. 5 per dollar.. In todays modern well connected and advanced markets, arbitrageurs (which are mainly banks) can spot it quickly and exploit the opportunity. Such opportunities vanish over a period of time and equilibrium is again maintained. For Eg. Bank A ` / $ = 50.50 / 50.55 Bank B ` / $ = 50.40 / 50.45 The above rates are very close. The arbitrageur may take advantage and he can purchase $ 1,00,000 from Bank B at `. 50.45 / a dollar and sell to it to Bank A at `. 50.50, thus making a profit of 0.05. The total profit would be (1,00,000 x 0.05) = `. 5,000. The profit is earned without any risk and blocking of capital. B. ARBITRAGE.AND INTEREST RATE Interest arbitrage refers to differences in interest rates in domestic market and in overseas markets. If interest rates are higher in overseas market than in domestic market, an investor may invest in overseas market to take the advantage of interest differential. Interest arbitrage may be covered and uncovered. 1) Uncovered Arbitrage In this system, arbitrageurs would take a risk to earn profit by investing in a high interest bearing risk free securities in a foreign market. His earnings would be according to his calculations if the currency of foreign market where he invested does not depreciate. If depreciation is equal to the difference in interest rate, the investor would not incur loss. However, if depreciation is more than interest rate, then the arbitrageur will incur loss. For Eg. In New York interest rate on 6 month Treasury Bill is 6% and in Spain it is 8%. An US investor may convert US dollars in EURO and invest in Spain, thereby taking an advantage of +2% interest rate. Now when bill matures, US investor will convert EURO into dollars. However, by that time EURO may have depreciated the US investor will get less dollars per EURO. If EURO depreciates by 1%, US investor will gain only +1% (+2 1%). If EURO depreciates by 2% or more, US investor will not gain anything or incur loss. If EURO appreciates, US investor will gain, +2% and interest rate differential
2) Covered Arbitrage International investors would like to avoid the foreign exchange risk, thus interest arbitrage is usually covered. The investor converts the domestic currency for foreign currency at the current spot rate for the purpose of investment. At the same time, investor sells forward the amount of foreign currency which he is investing plus the interest that he will earn so as to coincide with maturity of foreign investment. The covered interest arbitrage refers to spot purchase of foreign currency to make investment and offsetting simultaneous forward sale of foreign currency to cover foreign exchange risk. When treasury bills mature, the investor will get the domestic currency equivalent of foreign investment plus interest without a foreign exchange risk.