INTERNATIONAL FINANCE

Unit 1: Introduction to International Finance

Finance
MEANING
It is derived from the Latin word ‘finis’ which means money. It involves management of flow of
money through organization. In other words, it is a provision of money as and when required.
DEFINITION
• According to Bodie and Merton- “ finance is the study of scarce resource are allocated
over time”
• According to O.Ferrel C and Geoffrey Hirt, “ The term finance refers to “ all activities
related to obtaing money and its effective use”.
International Finance
MEANING
• Also known as multinational finance
• A branch of financial economics mostly concerned with monetary and macroeconomics
inter relations between two or more countries
• It studies the dynamics of exchange rate, foreign investment, global financial system and
how these effect international trade.
• it involves monitoring movements in foreign exchange rates, global investment flows and
cross border trade practices.
NEED FOR INTERNATIONAL FINANCE
• Efficiently produce products in foreign markets than that domestically.
• Obtain the essential raw materials needed for production
• Broaden markets and diversify
• Earn higher returns
• Effective financial planning and control
• Efficient allocation of funds among various assets
• Acquisition of funds on favorable terms
• Core factor for successful business operations
 FEATURES OF INTERNATIONAL FINANCE
• Foreign exchange risk
• Political risk
• Expanded opportunity sets
• Market imperfections
Foreign exchange risk:
1. Domestic economy- this risk is ignored, single national currency serves medium of
exchange.
2. Different national currencies- definite risk of volatility in foreign exchange rate.
3. Most serious international financial problem
Political risk:
Ranges from risk of loss or gains from unforeseen government actions or other events of a
political character such as acts of terrorism to outright expropriation of assets held by foreigners.,
Expanded opportunity sets
1. Firm benefits from expanded opportunities which are available now
2. Can raise funds in capital markets where cost of capital is lowest
Market imperfections
Difference among nation’s laws , tax systems , business practices and general cultural
environments- world markets to day highly imperfect.

Domestic finance International finance

Not exposed to foreign exchange risk and exposed to foreign exchange risk and political risks of trading
political risks of trading partner’s countries partner’s countries
As they tend to cross border for transactions

It is not subject to market imperfections subject to market imperfections

MNCs have to operate in different economies such as capitalist,
socialist and mixed economy.

The portfolio available for investment are limited portfolio available for investment are large across the nations in
the world

Access to global markets not possible Access to global markets possible and thereby expanding the
business opportunities

The scope is limited The scope is wider

DIFFERENCE BETWEEN DOMESTIC FINANCE & INTERNATIONAL FINANCE

IMPORTANCE OF INTERNATIONAL FINANCE

International finance plays a critical role in international trade and inter-economy exchange of
goods and services. It is important for a number of reasons, the most notable ones are listed here
1. International finance is an important tool to find the exchange rates, compare inflation
rates, get an idea about investing in international debt securities, ascertain the economic
status of other countries and judge the foreign markets.
2. Exchange rates are very important in international finance, as they let us determine the
relative values of currencies. International finance helps in calculating these rates.
3. Various economic factors help in making international investment decisions. Economic
factors of economies help in determining whether or not investors’ money is safe with
foreign debt securities.
4. Utilizing IFRS is an important factor for many stages of international finance. Financial
statements made by the countries that have adopted IFRS are similar. It helps many
countries to follow similar reporting systems.
5. IFRS system, which is a part of international finance, also helps in saving money by
following the rules of reporting on a single accounting standard.
6. International finance has grown in stature due to globalization. It helps understand the
basics of all international organizations and keeps the balance intact among them.
7. An international finance system maintains peace among the nations. Without a solid
finance measure, all nations would work for their self-interest. International finance
helps in keeping that issue at bay.
 8. International finance organizations, such as IMF, the World Bank, etc., provide a
mediators’ role in managing international finance disputes.
METHODS OF PAYMENT IN INTERNATIONAL TRADE
Cash-in-Advance
With cash-in-advance payment terms, an exporter can avoid credit risk because payment is
received before the ownership of the goods is transferred. For international sales, wire transfers
and credit cards are the most commonly used cash-in-advance options available to exporters.
With the advancement of the Internet, escrow services are becoming another cash-in-advance
option for small export transactions. However, requiring payment in advance is the least
attractive option for the buyer, because it creates unfavorable cash flow. Foreign buyers are also
concerned that the goods may not be sent if payment is made in advance. Thus, exporters who
insist on this payment method as their sole manner of doing business may lose to competitors
who offer more attractive payment terms.
Letters of Credit
Letters of credit (LCs) are one of the most secure instruments available to international traders.
An LC is a commitment by a bank on behalf of the buyer that payment will be made to the
exporter, provided that the terms and conditions stated in the LC have been met, as verified
through the presentation of all required documents. The buyer establishes credit and pays his or
her bank to render this service. An LC is useful when reliable credit information about a foreign
buyer is difficult to obtain, but the exporter is satisfied with the creditworthiness of the buyer’s
foreign bank. An LC also protects the buyer since no payment obligation arises until the goods
have been shipped as promised.
Documentary Collections
A documentary collection (D/C) is a transaction whereby the exporter entrusts the collection of
the payment for a sale to its bank (remitting bank), which sends the documents that its buyer
needs to the importer’s bank (collecting bank), with instructions to release the documents to the
buyer for payment. Funds are received from the importer and remitted to the exporter through the
banks involved in the collection in exchange for those documents. D/Cs involve using a draft that
requires the importer to pay the face amount either at sight (document against payment) or on a
specified date (document against acceptance). The collection letter gives instructions that specify
the documents required for the transfer of title to the goods. Although banks do act as facilitators
for their clients, D/Cs offer no verification process and limited recourse in the event of non-
payment. D/Cs are generally less expensive than LCs.
Open Account
An open account transaction is a sale where the goods are shipped and delivered before payment
is due, which in international sales is typically in 30, 60 or 90 days. Obviously, this is one of the
most advantageous options to the importer in terms of cash flow and cost, but it is consequently
one of the highest risk options for an exporter. Because of intense competition in export markets,
foreign buyers often press exporters for open account terms since the extension of credit by the
seller to the buyer is more common abroad. Therefore, exporters who are reluctant to extend
credit may lose a sale to their competitors. Exporters can offer competitive open account terms
while substantially mitigating the risk of non-payment by using one or more of the appropriate
trade finance techniques covered later in this Guide. When offering open account terms, the
exporter can seek extra protection using export credit insurance.
Consignment
Consignment in international trade is a variation of open account in which payment is sent to the
exporter only after the goods have been sold by the foreign distributor to the end customer. An
international consignment transaction is based on a contractual arrangement in which the foreign
distributor receives, manages, and sells the goods for the exporter who retains title to the goods
until they are sold. Clearly, exporting on consignment is very risky as the exporter is not
guaranteed any payment and its goods are in a foreign country in the hands of an independent
distributor or agent. Consignment helps exporters become more competitive on the basis of
better availability and faster delivery of goods. Selling on consignment can also help exporters
reduce the direct costs of storing and managing inventory. The key to success in exporting on
consignment is to partner with a reputable and trustworthy foreign distributor or a third-party
logistics provider. Appropriate insurance should be in place to cover consigned goods in transit
or in possession of a foreign distributor as well as to mitigate the risk of non-payment.

FUNDAMENTAL TERMS

1. Home currency: In the forex market, currency units are quoted as currency pairs. The

basecurrency – also called the transaction currency - is the first currency appearing in
a currency pair quotation, followed by the second part of the quotation, called the
quote currency or the counter currency.
2. Foreign Currency: the currency (i.e. money) of another country. A foreign currency account
is a bank account in the currency of another country (e.g. a dollar account in the UK).
3. Direct quote: A direct quote is a currency exchange rate between a domestic and foreign
currency in terms of the foreign currency. In other words, it compares how many domestic
units are required to purchase one foreign unit.

A direct quote is a foreign exchange rate quoted as the domestic currency per unit of the foreign
currency. In other words, it involves a quote in fixed units of foreign currency against variable
amounts of the domestic currency. As of February 2018, a direct quote of the U.S. dollar against
the Canadian dollar in the United States would be U.S. $0.79394 = C $1 while in Canada, a
direct quote for would be C $1.25953 = U.S. $1.

4. Indirect quote: 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. An indirect quote is also known as a “quantity quotation,” since it
expresses the quantity of foreign currency required to buy units of the domestic currency. In
other words, the domestic currency is the base currency in an indirect quote, while the foreign
currency is the counter currency.
 An indirect quote is the opposite or reciprocal of a direct quote, also known as a “price
quotation,” since it expresses the price of one unit of a foreign currency in terms of the
domestic currency.

5. Bid &Ask:‘Bid and Ask’ is a two-way price quotation that indicates the best price at which a
security can be sold and bought at a given point in time. The bid price represents the
maximum price that a buyer is willing to pay for a security. The ask price represents the
minimum price that a seller is willing to receive. A trade or transaction occurs after the buyer
and seller agree on a price for the security.

The difference between the bid and ask prices, or the spread, is a key indicator of
the liquidity of the asset. In general, the smaller the spread, the better the liquidity.

6. Spot & Forward rate:The price quoted for immediate settlement on a commodity, a security
or a currency. The spot rate, also called “spot price,” is based on the value of an asset at the
moment of the quote. ... As a result, spot rates change frequently and sometimes dramatically.

The term forward rate is commonly used in both bond and currency trading to express today's
expectation of the future value of either a currency or a bond. In bond trading the forward
rate is an implied rate calculated from current interest rates on various bond maturities.

7. Appreciation & Depreciation:Currency appreciation is an increase in the value of one

currency in terms of another. Currencies appreciate against each other for various reasons,
including government policy, interest rates, trade balances and business cycles.
Currency depreciation is the loss of value of a country's currency with respect to one or more
foreign reference currencies, typically in a floating exchange rate system in which no
official currency value is maintained. 
8. Cross currency rates: A cross rate is the currency exchange rate between two currencies,
both of which are not the official currencies of the country in which the exchange rate quote is
given in. This phrase is also sometimes used to refer to currency quotes which do not involve
the U.S. dollar, regardless of which country the quote is provided in. For example, if an
exchange rate between the euro and the Japanese yen was quoted in an American newspaper,
this would be considered a cross rate in this context, because neither the euro or the yen is the
standard currency of the U.S. However, if the exchange rate between the euro and the U.S.
dollar were quoted in that same newspaper, it would not be considered a cross rate because the
quote involves the U.S. official currency.

INTERNATIONAL MONETARY SYSTEM

Bretton woods system

The Bretton Woods Agreement is the landmark system for monetary and exchange rate
management established in 1944. It was developed at the United Nations Monetary and Financial
Conference held in Bretton Woods, New Hampshire, from July 1 to July 22, 1944. Under the
agreement, currencies were pegged to the price of gold, and the U.S. dollar was seen as a reserve
currency linked to the price of gold.

The Bretton Woods Agreement remains an important part of world financial history. The
creation of the International Monetary Fund (IMF) and valuation of gold and foreign exchange
rates remain important to this day. The agreement also made currencies convertible for trade and
other current account transactions. The strong value of the U.S. dollar eventually led to the
collapse of this system after more than 20 years.
The Bretton Woods Agreement

Delegates from 44 countries met to create a new international monetary system. The main goals
of the meeting of the 730 delegates were to ensure a foreign exchange rate system, prevent
competitive devaluations and promote economic growth.

Preparation for this event took two years. The primary designers of the system were John
Maynard Keynes, of the United Kingdom, and Harry Dexter White, the chief international
economist of the Treasury Department. Keynes’ plan was to establish a global central bank
called the Clearing Union. White’s plan limited the powers and resources of each country. In the
end, the adopted plan took ideals from both, leaning more toward White’s plan.

Creation of Two New Institutions

One of the major items that came about from the Bretton Woods Agreement was the creation of
the International Monetary Fund. The IMF was created to monitor exchange rates and lend
reserve currencies to nations. It was formally introduced in December 1945 when 29 members
signed the Articles of Agreement. The Bretton Woods Agreement also created the World Bank
Group, which was set up to provide financial assistance for countries during the reconstruction
post World War I phase.

End of Bretton Woods Agreement

The Bretton Woods Agreement was dissolved between 1968 and 1973. An overvaluation of the
U.S. dollar led to concerns over the exchange rates and tie to the price of gold. President Richard
Nixon called for a temporary suspension of the dollar’s convertibility. Countries were then free
to choose any exchange agreement, except the price of gold. In 1973, foreign governments let
currencies float, which put an end to the Bretton Woods system.

Weaknesses of Bretton woods Agreement

The Bretton Woods system of monetary system management created the rules for the
commercial and financial relations among the world’s major developing nations. Until the early
1970s, the Bretton Woods system was effective in maintaining the standard or fixed exchange
rates for the leading nations that had created it, especially the United Nations. Due to this fixed
exchange rate, countries experienced balance of payments deficit. This leads to increase in the
respective currency in the foreign exchange market. Hence, affects the exchange value of
that currency. The Central banks had to act at this time and failure to which might create a
financial crisis as it happened in the year 1956-58. French Franc crisis and problems of British
pound were the examples. The currencies of the respective nations when they were devalued to
correct the payment imbalances. Thus the delayed adjustment of the parties to change in the
economic environment of the countries was the weakest point of Bretton Woods Agreement.
This led to a lack of trust and strike at the foundation of guesswork.

Another considerable problem was that one national currency had to be an international reserve
currency at that time. This made the national monetary and economic policy of the United States
liberated from external fiscal pressures, while greatly influencing those foreign economies. To
guarantee international liquidity; the USA has enforced o run shortage in their balance of
payments, to avoid world inflation. However, in the 1960s they ran a policy that restricted the
convertibility of the U.S. dollar to compete for the insufficient reserves to meet the currency
supply and demand. But other member nations were not ready to accept the high inflation rates
and the value of dollar ended up being weak. Hence, the system of Bretton Woods collapsed.

Gold Standard System

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.

Gold standard refers to a system of maintaining gold reserves by countries central bank in order
to maintain the exchange rates and also government have to stock more gold before issuing fresh
currency into the country financial markets. This system is not followed presently, however in
view of recent economic events like housing bubble, euro crisis, violent exchange rate volatility
many people are advocating the use of gold standard. Given below are some of the advantages
and disadvantages of gold standard –

Advantages of Gold Standard

1. This system put brakes on government ability to print unlimited amount of money, and
we all have seen how from past few years central banks like fed and ECB have been
throwing money in the markets in order to save their economies but have been
unsuccessful and biggest side effect of these policies have been inflation and
speculation leading to more harm than benefits for the people of this globe.
2. Extreme volatility in currency is not desired by any country and in the past currencies
used to move 1 or 2 per cent during a month but in the past few months’ currencies of
many countries have been moving 1 to 2 per cent in intraday trade and exchange rate
 fluctuation of this magnitude can lead to huge losses for companies and ultimately
people will suffer due to it.
3. Current monetary system increases inefficiency and wasteful expenditure by the
governments because they know that they can print money whenever they want in
order to reduce their fiscal deficit which is not possible under gold standard system.

 Disadvantages of Gold Standard

1. Since gold is not divided equally it can lead to imbalances as countries having it as
natural resource can exploit countries that have less gold reserves.
2. Sometimes money supply is needed to push the economic activity as money can be
force multiplier for economic growth which is not possible under this system.
3. This system ties the hands of central banks and governments to tackle any economic
catastrophe and therefore whenever such things happen it can lead to complete collapse
of the world exchange system.
4. The argument that it does not lead to inflation may not hold true in case of supply side
inflation when there is general reduction in production of goods and services and also
when there is natural calamity like famine, floods, tsunami etc…, leading to drop in
production of agriculture production which increases the price of essential
commodities leading to inflation.

Floating exchange rate system

In a floating exchange rate system, when the demand for a currency is low, its value decreases
just as with any other product or service. But the result of a devalued currency is that imported
goods seem more expensive to the people holding that currency. What used to require $5 to buy
now requires $10. Because imported goods seem more expensive, people usually start buying
more domestic goods, which tends to create jobs and stimulate the economy in general.

However, the opposite is also true. When the currency becomes more valuable, imported items
seem cheaper, and suddenly people want to buy fewer domestically produced items. This tends
to increase unemployment and slow the economy in general.

Advantages of floating exchange rates

 Protection from external shocks - if the exchange rate is free to float, then it can change
in response to external shocks like oil price rises. This should reduce the negative impact
of any external shocks.
 Lack of policy constraints - the government are free with a floating exchange rate
system to pursue the policies they feel are appropriate for the domestic economy without
worrying about them conflicting with their external policy.
 Correction of balance of payments deficits - a floating exchange rate can depreciate to
compensate for a balance of payments deficit. This will help restore the competitiveness
 of exports. There is a link to Figure 1 below which illustrates the operation of the
automatic adjustment mechanism under a floating exchange rate system.

Disadvantages of floating exchange rates

 Instability - floating exchange rates can be prone to large fluctuations in value and this
can cause uncertainty for firms. Investment and trade may be adversely affected.
 No constraints on domestic policy - governments may be free to pursue inappropriate
domestic policies (e.g. excessively expansionary policies) as the exchange rate will not
act as a constraint.
 Speculation - the existence of speculation can lead to exchange rate changes that are
unrelated to the underlying pattern of trade. This will also cause instability and
uncertainty for firms and consumers.

Pegged exchange rate system

A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes.
Typically, a country will "peg" its currency to a major currency such as the U.S. dollar, or to a
basket of currencies. The choice of the currency (or basket of currencies) is affected by the
currencies in which the country's external debt is denominated and the extent to which the
country's trade is concentrated with particular trading partners. The case for pegging to a single
currency is made stronger if the peg is to the currency of a principal trading partner. If much of
the country's debt is denominated in other currencies, the choice of which currency to peg it to
becomes more complicated.

Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual
exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given
changes in economic fundamentals, the target exchange rate may be modified.

Pegged exchange rates are typically used by smaller countries. To defend a particular rate, they
may need to resort to central bank intervention, the imposition of tariffs or quotas, or the
placement of restrictions on capital flow. If the pegged exchange rate is too far from the actual
market rate, it will be costly to defend and it will probably not last. Currency speculators may
benefit from such a situation.Advantages of pegged exchange rates include a reduction in the
volatility of the exchange rate (at least in the short-run) and the imposition of some discipline on
government policies. One disadvantage is that it can introduce currency speculation.

Managed floating exchange rate system

A managed floating exchange rate is a regime that allows an issuing Central Bank to intervene
regularly in FX markets to change the direction of the currency’s float to support the stability of
its balance of payments in excessively volatile periods. This regime is also known as a “dirty
float”.

Until the 1980’s the vast majority of the world currencies were subject to some form of control,
but in the 1990s and with the advent of free trade and globalisation, most developed economies
gradually removed those checks, letting their currency’s exchange rate fluctuate according to
supply and demand.

Free floating regimes, however, present some disadvantages, the most obvious one is the impact
of sharp fluctuations in the country’s economy through the trade balance. Currency appreciation
increases the prices of the country’s exports, while currency depreciation might pose problems to
import first-need products such as energy or food.

Central Banks and governments have a broad range of tools to “manage” the exchange rates;
from the subtlest monetary policies to straightforward sales and purchases in currency markets.

In that sense, most of the world’s currencies are “managed” to a certain degree including the
most traded ones. Officially, the International Monetary Fund recognises 82 countries – 43% of
all countries –  that use a managed floating exchange rate in its 2014 report.