Welcome to:

International Finance

By
Amit Kumar
Harsh Kumar
Balkar Singh
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Why is International Finance
Important?

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 Why is International Finance
Important?
 Companies (and individuals) can raise funds,
invest money, buy inputs, produce goods and
sell products and services overseas.
 With these increased opportunities comes
additional risks. The need to know how to
identify these risks and then how to control or
remove them.

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What is different?

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 Multinational Enterprises

 A multinational enterprise (MNE) is defined as one

that has operating subsidiaries, branches or affiliates
located in foreign countries.
 While international finance focuses on MNEs,
purely domestic firms can also face significant
international exposures:
 Import & export of products, components and services
 Licensing of foreign firms to conduct their foreign
business
 Exposure to foreign competition in the domestic market
 Indirect exposure to international risks through
relationships with customers and suppliers

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 International Monetary System
 The International Monetary System is a set of rules that governs
international payments (exchange of money).
 Historical overview of exchange rate regimes:
 Classical Gold Standard: Pre - 1914
 Bretton Woods System: 1944 - 1973
 Floating Exchange Rates: 1973 -
 European Monetary Union

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 The Gold Standard (Pre - 1914)

 Gold has been a medium of exchange since 3,000 BC.

 “Rules of the game” were simple, each country set the
rate at which its currency unit could be converted to a
weight of gold.
 Currency exchange rates were in effect “fixed”.
 Expansionary monetary policy was limited to a
government’s supply of gold.
 Was in effect until the outbreak of WWI as the free
movement of gold was interrupted.

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 The Gold Standard (Pre - 1914)
An example:
 US dollar is pegged to gold at $20.67 per oz.
 British pound is pegged to gold at £4.2474 per oz.
 Therefore, the exchange rate is determined by the relative
gold prices:  $20.67 = £ 4.2474
Then £1 = $4.8665
 Misalignment in exchange rates and imbalances of
payment corrected by the price-specie flow
mechanism.
 Suppose it is $4/£ instead …
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 Price-Specie Flow Mechanism

Keep difference Buy gold in England Gold leaves England

and repeat until (cost = £4.2474 and enters U.S
exchange rate for 1 oz.) (English Central
is aligned. Bank sells gold
in exchange for £.)
Under gold standard,
any misalignment in
the exchange rate
Send those £5.1675 will automatically be
back to England Ship gold to U.S and
corrected by cross-
Sell for $20.67
border flows of gold.

Convert at going Gold is bought

exchange rate, get by the U.S.
£5.1675 Central Bank
and more $ are
released.

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Inter-war years
(1915- 1944)

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 The Inter-War Years & WWII

 During this period, currencies were allowed to

fluctuate over a fairly wide range in terms of gold
and each other.
 Increasing fluctuations in currency values became
realized as speculators sold short weak currencies.
 The US adopted a modified gold standard in 1934.
 During WWII and its chaotic aftermath the US
dollar was the only major trading currency that
continued to be convertible.

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 Bretton Woods (1944)

 As WWII drew to a close, the Allied Powers met at

Bretton Woods, New Hampshire to create a post-war
international monetary system.
 The Bretton Woods Agreement established a US
dollar based international monetary system and
created two new institutions the International
Monetary Fund (IMF) and the World Bank.

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 Bretton Woods (1944 – 1973)
 United States:
 USD was fixed in terms of gold (USD 35 per ounce).
 Other countries fixed their currency relative to the USD.
 Allowed to vary between  1% of the “par value”.

Pound Yen
Par value Par value

US dollar
Pegged at $35/oz

Gold

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 Bretton Woods (1944 – 1973)
 The currency arrangement negotiated at Bretton Woods and
monitored by the IMF worked fairly well during the post-WWII
era of reconstruction and growth in world trade.
 However, widely diverging monetary and fiscal policies,
differential rates of inflation and various currency shocks
resulted in the system’s demise.
 The US dollar became the main reserve currency held by
central banks, resulting in a consistent and growing balance of
payments deficit which required a heavy capital outflow of
dollars to finance these deficits and meet the growing demand
for dollars from investors and businesses.

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 Bretton Woods (1944 – 1973)

 Eventually, the heavy overhang of dollars held by foreigners

resulted in a lack of confidence in the ability of the US to met
its commitment to convert dollars to gold.
 The lack of confidence forced President Richard Nixon to
suspend official purchases or sales of gold by the US Treasury
on August 15, 1971.
 This resulted in subsequent devaluations of the dollar.
 Most currencies were allowed to float to levels determined by
market forces as of March, 1973.

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 Floating Exchange Rates (1973 – )

Since March 1973, exchange rates have

become much more volatile and less
predictable than they were during the “fixed”
period.

There have been numerous, significant

world currency events over the past 30 years.

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 European Monetary Union (EMU)
 1979 – 1998: European Monetary System
 Objectives:
 To establish a “zone of monetary stability” in Europe.
 To coordinate exchange rate policies vis-à-vis non
European currencies.
 To pave the way for the European Monetary Union.

 EMU (1999-): A single currency for most of the

European Union.

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 European Monetary Union (EMU)
 27 members of the European Union are:
 Austria, Belgium, Bulgaria, Czech, Cyprus, Denmark,
Estonia, Finland, France, Germany, Greece, Hungary, Ireland,
Italy, Latvia, Lithuania, Luxembourg, Malta, The
Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia,
Spain, Sweden, and the United Kingdom.
 Currently, twelve members of the EU have their
currencies pegged against the Euro (Maastricht Treaty)
beginning 1/1/99:
 Austria, Belgium, Finland, France, Germany, Greece, Ireland,
Italy, Luxembourg, The Netherlands, Portugal, Spain.

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 European Monetary Union (EMU)
 Benefits for countries using the € currency inside the
Euro zone include:
 Cheaper transaction costs.
 Currency risks and costs related to exchange rate uncertainty
are reduced.
 All consumers and businesses, both inside and outside of the
euro zone enjoy price transparency and increased price-
based competition.

i.e., exchange rate stability, financial integration.

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 European Monetary Union (EMU)
• Costs for countries using the € currency include:
– Completely integrated and coordinated national
monetary and fiscal policy rules:
• Nominal inflation should be no more than 1.5% above average
for the three members of the EU with lowest inflation rates
during previous year.
• Long-term interest rates should be no more than 2% above
average for the three members of the EU with lowest interest
rates.
• Fiscal deficit should be no more than 3% of GDP.
• Government debt should be no more than 60% of GDP.
• European Central Bank (ECB) was established to promote
price stability within the EU.
i.e., no monetary independence!
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 Fixed versus Floating

 A nation’s choice as to which currency regime to follow

reflects national priorities about all facets of the
economy, including:
– inflation,
– unemployment,
– interest rate levels,
– trade balances, and
– economic growth.

 The choice between fixed and flexible rates may change

over time as priorities change.
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 Fixed versus Floating

 Countries would prefer a fixed rate regime for the

following reasons:
– stability in international prices.
– inherent anti-inflationary nature of fixed prices.
 However, a fixed rate regime has the following
problems:
– Need for central banks to maintain large quantities of hard
currencies and gold to defend the fixed rate.
– Fixed rates can be maintained at rates that are inconsistent
with economic fundamentals.

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 Determinants of Exchange Rates

 Inflation
 Real Income
 Interest Rates
 Bilateral trade relationships
 Customer tastes
 Investment profitability
 Product availability
 Productivity changes
 Trade Policies
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 Types of Foreign Exchange Markets

 Inter-bank or wholesale market

A trading between banks is termed as the ‘inter-bank
market’ wherein banks can obtain quotes, or they can
contact brokers who sometimes act as intermediaries,
matching a bank desiring to sell a given currency with
another desiring to buy that currency
 Retail market
Retail market consists of travelers and tourists who
exchange one currency to another in the form of
travellers cheques or currency notes.
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Participants in the Foreign Exchange Market

 Traders use forward contract to eliminate or cover the

risk of loss on export or import orders that are
denominated in foreign currencies.
 Hedgers are mostly multinational firms engaged in
forward contracts to protect the home currency value
of various foreign currency-denominated assets and
liabilities.
 Arbitrageurs seek to earn risk-free profits by taking
advantage of differences in interest rates among
countries.

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 Exchange Rate Quotations

 Spot Vs Forward Quote

Spot rate is the price agreed for purchase or sale of foreign currency with delivery and
payment to take place not more than two business days after the day the transaction has
been concluded.
Forward rate is the price at which the foreign exchange rate is quoted for delivery at a
specified later date

 Direct Vs. Indirect Quotes

Under direct quotes, units of the home currency per unit of a foreign currency are quoted.
Indirect quote is known a reciprocal or inverse quote to indicate units of foreign currency
per unit of home currency.

 Bid vs ask quotations

The price that a bank is willing to pay for a foreign currency is termed as bid rate whereas
the price at which a bank is willing to sell the currency is known as ask or offer rate.

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 Strategy to manage
Foreign Exchange Fluctuations
When the domestic currency is weak
- Stress price benefits
- Expand product line and add more costly features
- Shift sourcing and manufacturing to the domestic market
- Exploit export opportunities in all markets
- Conduct conventional cash-for-goods trade
- Use full-costing approach, but use marginal-cost pricing to penetrate new or
competitive markets.
- Speed repatriation of foreign-earned income and collections
- Minimize expenditures in local, host country currency
- Buy needed services (advertising, insurance, transportation, etc.) in domestic market
- Minimize local borrowings.
- Bill foreign customers in domestic currency

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 Strategy to manage
Foreign Exchange Fluctuations
When the domestic currency is strong
- Engage in non-price competition by improving quality, delivery and after-sales
service.
- Improve productivity and engage in various cost reduction.
- Shift sourcing and manufacturing overseas
- Give priority to exports to relatively strong-currency countries.
- Deal in counter trade with weak-currency countries.
- Cut profit margins and use marginal-cost pricing.
- Keep the foreign-earned income in host country, show collections.
- Maximize expenditures in local, host-country currency
- Buy needed services abroad and pay for them in local currencies
- Borrow money needed for expansion in local market.
- Bill foreign customers in their own currency.

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 MODES OF PAYMENT IN
INTERNATIONAL TRADE
 Advance Payment – Under this payment is remitted by the buyer in advance, either
by a draft mail or telegraphic transfer
 Documentary credit – The two principal documents used in documentary collection
are the bills of lading issued by the shipping company and the draft (bill of
exchange) drawn by the merchandise for the carriage.

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 International Trade Finance

The choice of trade finance strategy depends upon

several factors: -
- Financing alternatives available
- Nature of goods sold, as capital goods require long-term financing whereas
perishables or consumer goods require short-term financing
- Intensity of market competition; exporters are expected to offer long-term
credit to import in buyers’ market, whereas the reverse is the case in sellers’
market
- Relationship between the exporter and the importer.

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 International Trade Finance

Types of international financing alternatives

- Banker’s acceptance
- Discounting
- Accounts receivable financing
- Factoring
- Forfeiting
- Letters of credit
- Counter trade

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Thank You !

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