International 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, multicurrency 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.
Introduction to Forex Market:
For most of us, the focal point of understanding international finance revolves
around foreign exchange market. The foreign exchange market (also known as
the currency, forex, or FX) is where currency trading takes place. It is a market
where banks, companies, exporters, importers, fund managers, individuals,
central banks of different countries buy and sell of foreign currencies. Forex
trading involves a foreign exchange transaction, defined as the simultaneous
buying of one currency and selling of another currency. As forex rates are quoted
in pairs, e.g. Euro/US$, US$/Japanese Yen, US$/INR, etc., a trader trading in forex
sells one of the currency pair and buys the other.
DEFINITION OF 'FOREIGN EXCHANGE MARKET'
The market in which participants are able to buy, sell, exchange and speculate
on currencies. Foreign exchange markets are made up of banks, commercial
companies, central banks, investment management firms, hedge funds, and
retail forex brokers and investors. The forex market is considered to be the
largest financial market in the world.
INVESTOPEDIA EXPLAINS 'FOREIGN EXCHANGE MARKET'

Because the currency markets are large and liquid, they are believed to be the
most efficient financial markets. It is important to realize that the foreign
exchange market is not a single exchange, but is constructed of a global network
of computers that connects participants from all parts of the world.
For example- if an US car company wants to buy a uk car engine then us have to
convert their dollar into pounds and then pay them the money.this conversion is
done with the help of foreign exchange market.
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.

Difference between Spot Market and Forward Market!

Foreign exchange markets are sometimes classified into spot market and forward
market on the basis of the period of transaction carried out. It is explained below:

(a) Spot Market:

If the operation is of daily nature, it is called spot market or current market. It
handles only spot transactions or current transactions in foreign exchange.
Transactions are affected at prevailing rate of exchange at that point of time and
delivery of foreign exchange is affected instantly. The exchange rate that prevails
in the spot market for foreign exchange is called Spot Rate. Expressed
alternatively, spot rate of exchange refers to the rate at which foreign currency is
available on the spot.

For instance, if one US dollar can be purchased for Rs 40 at the point of time in
the foreign exchange market, it will be called spot rate of foreign exchange. No
doubt, spot rate of foreign exchange is very useful for current transactions but it
is also necessary to find what the spot rate is. In addition, it is also significant to
find the strength of the domestic currency with respect to all of home countrys
trading partners. Note that the measure of average relative strength of a given
currency is called Effective Exchange Rate (EER).
(b) Forward Market:
A market in which foreign exchange is bought and sold for future delivery is
known as Forward Market. It deals with transactions (sale and purchase of foreign
exchange) which are contracted today but implemented sometimes in future.
Exchange rate that prevails in a forward contract for purchase or sale of foreign
exchange is called Forward Rate. Thus, forward rate is the rate at which a future
contract for foreign currency is made.
This rate is settled now but actual transaction of foreign exchange takes place in
future. The forward rate is quoted at a premium or discount over the spot rate.
Forward Market for foreign exchange covers transactions which occur at a future
date. Forward exchange rate helps both the parties involved.
A forward contract is entered into for two reasons:
(i) To minimise risk of loss due to adverse change in exchange rate (i.e., hedging)
and [ii] to make a profit (i.e., speculation).
Two Exchange rate quotes: In foreign exchange market, there are two exchange
rate quotes, namely, buying rate and selling rate. If a person goes to the
exchange market to buy foreign currency, say, US dollars, he has to pay higher
rate than when he goes to sell dollars. In other words, for a person buying rate is
higher than selling rate.
Appreciation and Depreciation
The exchange rate for any currency usually fluctuates. When the value of the
currency goes up as compared to other currency it is known as appreciation.
When the value of currency falls as compared to other currency it is known as
depreciation.
Usually the exchange rates are determined by the demand and supply of that
currency in the international market.
Demand for any countrys currency on the foreign exchange market is
determined by demand for that countrys exports of goods and services and by
changes in foreign investment in that country. This is because when foreigners
buy another countrys exports of goods or services they must pay for these in
the currency of the exporting country.

In the same way Supply of any countrys currency on the foreign exchange
market is determined by that countrys imports of goods and services and by its
investment in other countries.
Thus when the demand for a currency rises its price goes up and it becomes
costlier.
Bid-Ask Spread
The spot quotations discussed in Session 11, were given as one rate i.e, USD/INR
42.75. However, in real life, like any market place, buyers and sellers give their
buying and selling rate. Hence at a given point of time, there are two rates
available.These two rates are known as bid and ask rates. As discussed in
Session 4 (market participants in foreign exchange market), forex dealers give
both bid rates and ask rates. Bid-ask rates are given by forex dealers who are
willing to buy and sell forex at these rates. It is to be noted here that in a
traditional market, the buyers and sellers are normally separate entities. For
example, buyers and sellers of steel would be different. A buyer is an user of the
steel while seller is the producer of the steel. However in a forex market buyers
and sellers can be individual entities (exporters or importers) as well as a single
entity buying and selling a currency simultaneously. The difference between
these two rates is known as bid-ask spread.
Different aspect of bid and ask rates are discussed in the session i.e, what is bidask rates, how banks use the bid-ask rates to change the inventory of the
currency they hold, how bid-ask price in Indian spot market has changed
significantly over the years and how demand and supply of a currency impacts
the bid-ask spread.
Bid-Ask Rates:

Bid Ask spread determines the profit for the bank. It is very important to
understand at this point is, bid price is always lesser than ask price.

Spot Rates and Cross Rates: