International Finance Tutorial
International FinanceAbout the TutorialInternational Finance deals with the management of finances in a global business. Itexplains how to trade in international markets and how to exchange foreign currency, andearn profit through such activities.This tutorial provides a brief overview of the current trends in finance, along with detailedinputs on the current global markets, foreign exchange markets, international capitalmarkets, hedging and risk management, and strategic decision-making.AudienceThis tutorial is an easy and informative read for management students and financeprofessionals. The objective of this tutorial is to equip the readers with an understandingof the international financial system and its growing importance.PrerequisitesTo understand this tutorial, it is advisable to have a foundation level knowledge of businessand macroeconomics. However, general students who wish to get a brief overviewInternational Finance may find it quite useful.Copyright & Disclaimer Copyright 2019 by Tutorials Point (I) Pvt. Ltd.All the content and graphics published in this e-book are the property of Tutorials Point (I)Pvt. Ltd. The user of this e-book is prohibited to reuse, retain, copy, distribute or republishany contents or a part of contents of this e-book in any manner without written consentof the publisher.We strive to update the contents of our website and tutorials as timely and as precisely aspossible, however, the contents may contain inaccuracies or errors. Tutorials Point (I) Pvt.Ltd. provides no guarantee regarding the accuracy, timeliness or completeness of ourwebsite or its contents including this tutorial. If you discover any errors on our website orin this tutorial, please notify us at contact@tutorialspoint.comi
International FinanceTable of ContentsAbout the Tutorial . iAudience . iPrerequisites . iCopyright & Disclaimer . iTable of Contents . iiPART 1 – INTERNATIONAL FINANCE AND GLOBAL MARKETS . 11.International Finance – Introduction. 2Importance of International Finance . 32.Financial Globalization . 4Driving Forces of Financial Globalization . 4Changes in Capital Markets. 4Benefits and Risks of Financial Globalization . 5Safeguarding Financial Stability. 5PART 2 – FOREIGN EXCHANGE MARKETS . 63.Balance of Payments. 7Current Account and Capital Account. 7BOP Table for a Hypothetical Country . 8BOP Imbalances. 9Reasons behind BOP Imbalances. 9Reserve Assets. 10BOP Crisis . 10How to Correct BOP Imbalances . 104.Forex Market Players . 12Commercial and Investment Banks . 13Central Banks . 13Businesses and Corporations . 14Fund Managers, Hedge Funds, and Sovereign Wealth Funds . 15Internet-based Trading Platforms . 16Online Retail Broker-Dealers . 17PART 3 – INTERNATIONAL CAPITAL MARKETS. 185.THE INTEREST RATE PARITY MODEL . 19What is Interest Rate Parity? . 19Covered Interest Rate Parity (CIRP) . 21Uncovered Interest Rate Parity (UIP). 21Covered Interest Rate and Uncovered Interest Rate . 22Implications of IRP Theory . 226.Monetary Assets . 23Demand and Supply of Currency in Forex Market. 23ii
International Finance7.Exchange Rates . 24Changes in Exchange Rates . 258.Interest Rates. 269.Forex Intervention . 27Why Forex Intervention? . 27Non-intervention . 27Direct Intervention . 28Indirect intervention. 2910. International Money Market . 31The International Money Market . 31The International Monetary Market. 32The Drawbacks of Currency Futures . 32A System for Transactions. 32Financial Crises and Liquidity . 3311. International Bond Markets . 34Domestic Bonds. 34Foreign Bonds . 34Eurobonds . 34International Bond market participants. 35International Bond Market Size. 35International Bond Market Volatility . 35Bond Investments. 35Bond Indices . 3612. International Equity Markets . 37Market Structure, Trading Practices, and Costs . 37Trading In International Equities . 38American Depository Receipts (ADR) . 38Global Registered Shares (GRS) . 39Factors Affecting International Equity Returns . 39PART 4 – HEDGING AND RISK MANAGEMENT . 4113. Exchange Rate Forecasts . 42Exchange Rate Forecast: Approaches . 42Exchange Rate Forecast: Models. 4214. Exchange Rate Fluctuations . 45Types of Exposure. 45Economic Exposure – An Example . 45Calculating Economic Exposure . 46Determining Economic Exposure . 47Managing Economic Exposure . 4715. Foreign Currency Futures & Options . 48Long and Short Currency Trading . 48Foreign Currency Futures. 48Options on Currency Pairs. 48Options on Currency Futures . 49iii
International FinanceDifference between Options and Futures . 4916. Transaction Exposure . 50Financial Techniques to Manage Transaction Exposure . 50Transaction Hedging Under Uncertainty . 51Operational Techniques for Managing Transaction Exposure . 5117. Translation Exposure . 53Translation Exposure – An Exhibit . 53Hedging Translation Exposure. 5418. Economic Exposure . 56Regression Equation . 56Economic Exposure –. 56A Practical Example . 56Techniques to Reduce Economic Exposure . 58PART 5 – STRATEGIC DECISION-MAKING . 6019. Foreign Direct Investment. 61FDI – Definition. 61FDI and its Types. 61Why is FDI Important? . 62FDI – Basic Requirements. 6320. Long-term and Short-term Financing . 64Long-Term Financing . 64Short-Term Financing . 6521. Working Capital Management . 67Why Firms Hold Cash . 67Float . 67Ways to Manage Cash . 6822. International Trade Finance . 70International Trade Payment Methods. 70Trade Finance Methods . 71iv
International FinancePart 1 – International Finance and Global Markets1
International Finance1. INTERNATIONAL FINANCE – INTRODUCTIONInternational Finance is an important part of financial economics. It mainly discusses theissues related with monetary interactions of at least two or more countries. Internationalfinance is concerned with subjects such as exchange rates of currencies, monetarysystems of the world, foreign direct investment (FDI), and other important issuesassociated with international financial management.Like international trade and business, international finance exists due to the fact thateconomic activities of businesses, governments, and organizations get affected by theexistence of nations. It is a known fact that countries often borrow and lend from eachother. In such trades, many countries use their own currencies. Therefore, we mustunderstand how the currencies compare with each other. Moreover, we should also havea good understanding of how these goods are paid for and what is the determining factorof the prices that the currencies trade at.Note: The World Bank, the International Finance Corporation (IFC), theInternational Monetary Fund (IMF), and the National Bureau of Economic Research(NBER) are some of the notable international finance organizations.International trade is one of the most important factors of growth and prosperity ofparticipating economies. Its importance has got magnified many times due toglobalization. Moreover, the resurgence of the US from being the biggest internationalcreditor to become the largest international debtor is an important issue. These issues area part of international macroeconomics, which is popularly known as international finance.2
International FinanceImportance of International FinanceInternational finance plays a critical role in international trade and inter-economyexchange of goods and services. It is important for a number of reasons, the most notableones are listed here: International finance is an important tool to find the exchange rates, compareinflation rates, get an idea about investing in international debt securities, ascertainthe economic status of other countries and judge the foreign markets. Exchange rates are very important in international finance, as they let us determinethe relative values of currencies. International finance helps in calculating theserates. Various economic factors help in making international investment decisions.Economic factors of economies help in determining whether or not investors’ moneyis safe with foreign debt securities. Utilizing IFRS is an important factor for many stages of international finance.Financial statements made by the countries that have adopted IFRS are similar. Ithelps many countries to follow similar reporting systems. IFRS system, which is a part of international finance, also helps in saving moneyby following the rules of reporting on a single accounting standard. International finance has grown in stature due to globalization. It helps understandthe basics of all international organizations and keeps the balance intact amongthem. An international finance system maintains peace among the nations. Without asolid finance measure, all nations would work for their self-interest. Internationalfinance helps in keeping that issue at bay. International finance organizations, such as IMF, the World Bank, etc., provide amediators’ role in managing international finance disputes.The very existence of an international financial system means that there are possibilitiesof international financial crises. This is where the study of international finance becomesvery important. To know about the international financial crises, we have to understandthe nature of the international financial system.Without international finance, chances of conflicts and thereby, a resultant mess, isapparent. International finance helps keep international issues in a disciplined state.3
International Finance2. FINANCIAL GLOBALIZATIONIn the last two decades, the financial economies have increasingly got interconnectedaround the world. The impact of globalization has been felt in every aspect of economy.Financial globalization has offered substantial benefits to the national economies and toboth investors and wealth creators. However, it has a wreaking effect on financial marketsas well.Driving Forces of Financial GlobalizationWhen we talk about financial globalization, there are four major factors to be considered.They are: es:Technological advancements have made market players and governments far moreefficient in collecting the information needed to manage financial risks. Globalization of national economies: Economic globalization has madeproduction, consumption, and investments dispersed over various geographiclocations. As barriers to international trade have been lowered, international flowsof goods and services have dramatically increased. Liberalization of national financial and capital markets: Liberalization andfast improvements in IT and the globalization of national economies have resultedin highly spread financial innovations. It has increased the growth of internationalcapital movements. Competition among intermediary services providers: Competitionhas increased manifold due to technological advancements and financialliberalization. A new class of nonbank financial entities, including institutionalinvestors, have also emerged.Changes in Capital MarketsThe driving forces of financial globalization have led to four dramatic changes in thestructure of national and international capital markets. First, banking systems have been under a process of disintermediation. Financialintermediation is happening more through tradable securities and not through bankloans and deposits. Second, cross-border financing has increased. Investors are now trying to enhancetheir returns by diversifying their portfolios internationally. They are now seekingthe best investment opportunities from around the world. Third, the non-banking financial institutions are competing with banks in nationaland international markets, decreasing the prices of financial instruments. They aretaking advantage of economies of scale.4
International Finance Fourth, banks have accessed a market beyond their traditional businesses. It hasenabled the banks to diversify their sources of income and the risks.Benefits and Risks of Financial GlobalizationOne of the major benefits of Financial Globalization is that the risk of a "credit crunch" hasbeen reduced to extremely low levels. When banks are under strain, they can now raisefunds from international capital markets.Another benefit is that, with more choices, borrowers and investors get a better pricing ontheir financing. Corporations can finance the investments more cheaply.The disadvantage is that the markets are now extremely volatile, and this can be a threatto financial stability. Financial globalization has altered the balance of risks in internationalcapital markets.With financial globalization, creditworthy banks and businesses in emerging markets cannow reduce their borrowing costs. However, emerging markets with weak or poorlymanaged banks are at risk.Safeguarding Financial StabilityThe crises of the 1990s have shown the importance for a prudent sovereign debtmanagement, effective capital account liberalization, and management of domesticfinancial systems.Private financial institutions and market players can now contribute to financial stabilityby managing their businesses well and avoiding unnecessary risk-taking.As financial stability is a global public good, governments and regulators also play a keyrole in it. The scope of this role is increasingly getting international.The IMF is a key role-player as well. Its global surveillance initiatives to enhance its abilityto manage international financial stability must also stay in track.5
International FinancePart 2 – Foreign Exchange Markets6
3. BALANCE OF PAYMENTSInternational FinanceIt is important to measure the performance of an economy. Balance of Payment (BOP)is one way to do so. It shows the big picture of the total transactions of an economy withother economies. It takes the net inflows and outflows of money into account and thendifferentiates them into sections. It is important to balance all accounts of BOP in case ofan imbalance so that the economic transactions can be measured and taken into accountin a systematic and prudent manner.Balance of Payment is a statement that shows an economy’s transactions with theremaining world in a given duration. Sometimes also called the balance of internationalpayments, BOP includes each and every transaction between a nation’s residents and itsnonresidents.Current Account and Capital AccountAll the transactions in BOP are classified into two accounts: the current account and thecapital account. Current account: It denotes the final net payment a nation is earning when it isin surplus, or spending when it is in deficit. It is obtained by adding the balanceof trade (exports earnings minus imports expenses), factor income (foreigninvestment earning minus expenses for investment in a foreign country) and othercash transfers. The current word denotes that it covers transactions that arehappening "here and now". Capital account: It shows net change in foreign-asset-ownership of a nation. Thecapital account consists the reserve account (the net change of foreign exchangeof a nation's central bank in market operations), loans and investments madeby the nation (excluding the future interest payments and dividends yielded byloans and investments). If net foreign exchange is negative, the capital account issaid to be in deficit.BOP data does not include the real payments. Rather, it is involved with the transactions.This means that the figure of BOP may differ significantly from net payments made to anentity over a period of time.BOP data is crucial in deciding the national and international economic policy. Part of theBOP, such as current account imbalances and foreign direct investment (FDI), are veryimportant issues which are addressed in the economic policies of a nation. Economicpolicies with specific objectives impact the BOP.7
International FinanceThe Tweak in Case of IMFThe IMF's BOP terminology uses the term "financial account" to include the transactionsthat would under alternative definitions be included in the general capital account. TheIMF uses the term capital account for a subset of transactions that form a small part ofthe overall capital account. The IMF calculates the transactions in an additional top leveldivision of the BOP accounts.The BOP identity, according to IMF terminology, can be written as:Current account Financial account Capital account Balancing item 0According to IMF, the term current account has its own three leading sub-divisions,which are: the goods and services account (the overall trade balance), the primaryincome account (factor income), and the secondary income account (transfer payments).Points to Note BOP is an account to show the expenses made by consumers and firms on importedgoods and services. BOP is also a pointer to how much the successful firms of a country are exportingto foreign countries. The money or the foreign currency entering a nation is taken as a positive entry(e.g. exports sold to foreign countries) The money going out or expenses of foreign currency is adjusted as a negativeentry (e.g. imports such as goods and services)8
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International Finance 3 Importance of International Finance International finance plays a critical role in international trade and inter-economy exchange of goods and services. It is important for a number of reasons, the most notable ones are listed here: International finance is an important tool to find the exchange rates, compare
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10 Catalogue des cours/Course Catalog 2021-2022 FIN: Finance/Finance E : Finance d'entreprise/Corporate Finance G : Finance générale/General Finance M : Finance de marché/Market Finance S : Synthèse/Synthesis IDS: Systèmes d'Information, Sciences de la Décision et Statistiques/ Information Systems, Decision Sciences and Statistics
Tutorial Process The AVID tutorial process has been divided into three partsÑ before the tutorial, during the tutorial and after the tutorial. These three parts provide a framework for the 10 steps that need to take place to create effective, rigorous and collaborative tutorials. Read and note the key components of each step of the tutorial .
Tutorial Process The AVID tutorial process has been divided into three partsÑ before the tutorial, during the tutorial and after the tutorial. These three parts provide a framework for the 10 steps that need to take place to create effective, rigorous and collaborative tutorials. Read and note the key components of each step of the tutorial .
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