Professional Documents
Culture Documents
July 2015
Dr. Dhirendra Gautam
Ph.D., CA, CMA & CWA
Agenda
v Introduction
v Course Content
v What is Finance
v International Finance
v Domestic Finance
v Domestic Vs. International Finance
v Why International Finance
International
Finance
Me
You
Introduction
Introduction
Introduction
International Financial
Course Content:
Foreign Exchange
SL.No
1
2
3
Particulars
FOREIGN EXCHANGE RATES
Theories of exchange rates. Purchasing power parity theory. Demand supply and elasticities in foreign exchange rate determination. Balance of Payments theory. Historical perspective on
exchange rate. Gold Standard, Inter-war instability, Bretton Woods, Fixed exchange rates, fluctuating exchange rates.
Case for Fixed or fluctuating exchange rates. The changing nature of world money. The rise of private world money. Eurocurrencies, Eurodollars, European Currency Unit, C. R. U their
mechanics and impact. International capital - flows and shocks. International debt problem - its origin, history and status. International liquidity and SDRs.
International Financial Institutions - International Monetary Fund, World Bank, International Finance Corporation, Washington D. C., Asian Development Bank.The basics of currency
trading. Foreign exchange dealers. Clearing, hedging, speculation in foreign exchange markets. Forward exchange rate, forward against spot exchange rate. Factors causing exchange rate
fluctuations.
BALANCE OF PAYMENTS (Structure and Equilibrium)
Balance of Payments definition. Component of Balance of Payments. Current Account, Capital Account, Balance of Payments Models, Basic balance. Disequilibrium in Balance of
Payments. Measures to correct disequilibrium in Balance of Payments.
FOREIGN EXCHANGE MARKETS
Operations of foreign exchange markets. Modes and mechanism of spot and forward exchange contracts. Exchange trading and position. Syndication. Swaps. Options, Offshore banking.
International Money, Capital and Foreign Exchange Markets with reference to New York, London, Tokyo, Hong Kong and Singapore.
MECHANICS OF FOREIGN EXCHANGE MARKETS
Contracts, Credits and Documentation. Sale and Purchase Contracts. Risks in international transactions. Incoterms, their importance and their applicability. Payments under trade contracts.
Documentary credits. Types of credits. Important credit clauses. Procedure for establishing credits.
Documents in foreign trade. Financial, Commercial, transport, insurance and other documents. Arbitration and conciliation.
ECONOMIC UNIONS AND TRADE AGREEMENTS
Theory of Custom Union. Political economy of trade barriers. Protection in world trade - a historical perspective. International Trade Organization (ITO). General Agreement on tariffs and
Trade (GATT). Kennedy Round. UNCTAD. Generalised System of Preferences (GSP). Tokyo Round. New International Economic Order. Brandt Commission and economic integration.
Uruguay Round. North South divide and dialogue. European Economic Community (EEC) and integration 1992. Impact of currency blocks on world trade and exchange.
INDIA'S FOREIGN TRADE PROMOTION AND CONTROL :
India's economy in global perspective. India's external debt. Export promotion strategy and policy. Export promotion measures. Commercial Policy. Non-Resident Investments and
Accounts.
The Export-Import Bank of India- its functions, resources, organization, management and current operations.
Export Credit Guarantee Corporation (ECGC) - its function, policy, management and current operations.
Financing of foreign trade. Types of credits, guarantees, bid bonds etc. Mechanism of Operations.
Foreign exchange controls - Objectives, exchange management and controls in India. FERA/ FEMA and its important provisions. Import Export Policy and procedures.
Case Studies and Presentations
What is
Finance?
How
to
earn
How
to
Manage
Finance
Money
Management
How
to
Expend
Accounts
Finance
Economics
Managing
BOTH,
Money and
Resource
CFO
/
CEO
Finance
Management
Managing
the
Finance of
Any
Business
Decision
Management
Business
Management
Managing
the
Resource
of
Any
Business
International
Finance
International Finance
Meaning
of
International
Finance:
v International Finance is an area of financial economics that deals with
monetary interactions between two or more countries.
v More Specifically:
v Foreign (Currency) exchange rates,
v International monetary systems,
v Foreign direct investment,
v International financial management including
v Political risk and foreign exchange risk inherent in managing multinational
corporations.
Domestic
Finance
Equity Holder
Financing
D ecision
A
&
B
S tarted
a
Business
w ith
high
potential
of
S uccess
Not
had
enough
Money
so
they
got
approach
and
convince
Mr.
C
for
initial
funding
Priority
Payment
to
Mr.
D
Money
Machine
An
E- Commerce
Portal
for
S elling
Cosmetics
Products
Online
More
Money
Loan Holder
Investing
D ecision
Still
Not
enough
Money
so
they
approach
Mr.
D
,
But
D
says
I
w ill
not
invest
but
I
w ill
Lend
Money
to
your
Business
Dividend Decision
Payment
to
A,
B
&
C
Loan Holder
Equity Holder
Financing
D ecision
A
&
B
S tarted
a
Business
w ith
high
potential
of
S uccess
Not
had
enough
Money
so
they
got
approach
and
convince
Mr.
C
for
initial
funding
Money
Machine
An
E- Commerce
Portal
for
S elling
Cosmetics
Products
Online
More
Money
Dividend
Decision
Investing D ecision
Priority
Payment
to
Mr.
D
5&6
Sources
of
Finance
Cost
of
Capital
&
Capital
Structure
Payment
to
A,
B
&
C
Financial Management
Financial
Manage
ment
Financing
Decision
A.
B.
Cost
of
Capital
Capital
Structure
Decisions
Investing
Decision
A.
B.
Capital
Budgeting
Working
Capital
Management
Dividend
Decision
A.
B.
Dividend
Policy
B.
Retained
- Earnings
Why ?
International
Finance
Domestic Vs.
International
Finance
Foreign
Exchange
Foreign Exchange
The total turnover in Forex Market apprx. US dollar 1.5 trillion per
day. Indian Market USD 1.20 BN per day.
Round the clock market starting from Sydney and Tokyo in the east
through Hong Kong, Singapore, Bahrain, London and New York.
participants are central banks , commercial banks, investment
funds, corporate, individuals and brokers.
Over the counter market
Foreign Exchange
Theories of exchange rates.
v Purchasing power parity theory (PPP)
v Demand supply and elasticity in foreign exchange rate determination.
v Balance of Payments theory.
v Historical perspective on exchange rate.
v Gold Standard,
v Inter-war instability,
v Bretton Woods,
v Fixed exchange rates,
v Fluctuating exchange rates.
For example, lets assume a currency appreciation The euro against the
US dollar.
Firstly, the exports of the European Union (E.U) nations will become
expensive for the United States of America (USA), which among other
things means that E.U product will lose in terms of competitiveness.
Secondly, such a currency appreciation will be to the benefit of E.U
imports, should those be payable in US dollars. Conversely, a depreciation
of the euro against the US dollar will cause an opposite impact.
On the other hand, the rapid growth of international trade (both the import
penetration and the export ratio) during the last decades, which was mainly
due to the increase of the open economies, enhances the significance of the
foreign exchange rates.
Governments have always paid very serious attention to the exchange rate of a countrys
currency, utilizing any available means at hand, in order to stabilize the desirable
range of rate.
Historically, there were periods that governments through the central banks
intervened in the foreign exchange market in order to affect the fluctuation of the
exchange rate that otherwise would be determined by market forces.
There were also periods with no intervention when the exchange rate, just like a price
was determined by supply and demand.
On 22nd July, 1944, at Bretton Woods in the United States of America, 44 countries
agreed that a broad international action was necessary to maintain an international
monetary system, which would promote foreign trade.
In this respect, it established a worldwide system of fixed exchange rates between currencies.
Actually, the tool was gold, with the following quota: one ounce of gold was to be worth US
dollars 35. After the establishment of the fixed rate of exchange, all other currencies were pegged
to the US dollar at a fixed exchange rate.
The End Of the "Fixed" Dollar, by the beginning of the 1960s, the US dollar 35 = 1 oz. gold
ratio was becoming more and more difficult to sustain. Gold demand was rising and the U.S. Gold
reserves were declining.
On 15th August, 1971, President Nixon, repudiated the international obligation of the U.S. to
redeem its dollar in gold. By the end of 1974, gold had soared from $35 to $195 an ounce.
Since the collapse of the Bretton Woods agreement (February 1973), the world's currencies have
"floated" with respect to the US dollar.
Thus, the foreign exchange rate regime changed from a fixed exchange rate to a flexible or
floating exchange rate. A system in which, exchange rates are determined by supply and demand
that is called clean float or where governments through central banks intervene (buy and sell
currencies) in the markets, which is called dirty float.
Undoubtedly, dramatic movements in the value of currencies can occur where the forces of supply
and demand freely determine the price.
Consequently, such a system increases the exchange rate risk associated with but not limited to
international transactions.
The cross-border financial activity differs from the domestic activity in respect to related risk due
to the fact that when investing in a foreign country you have to consider many other factors, such
as:
In addition, the likely volatility in the exchange rate can drastically affect the cost, profits and
return on investments of international firms, thus, resulting in the following levels of risk:
Additionally the volatility in the exchange rate can drastically affect the cost, profits and return on
investments of international firms, thus, resulting in the following levels of risk:
Translation exposure
Assuming a company that has a subsidiary outside the EU and expects profits in one years time.
Based on the current exchange rate between foreign and domestic currency, the company has
converted the amount of profits in its local currency. If the euro appreciates against the local
currency, then the amount of profits when converted into Euros will be less.
As stated earlier, the exchange rate, just like commodities, determines its price responding to the
forces of supply and demand.
Therefore, if for some reason people increase their demand (shift of the curve from D to D1) for a
specific currency, then the price will rise from A to B, provided the supply remains stable. On the
contrary, if the supply is increased (shift of the curve from S to S1), the price will decline from A to
C, provided the demand remains stable.
Any excess supply (above the equilibrium point) or excess demand (below the equilibrium point)
will increase or decrease temporarily foreign currency reserves accordingly.
Finally, such disequilibrium situations will be eliminated through the pricing, e.g. the market itself.
Therefore, if for some reason people increase their demand (shift of the curve from D to D1) for a
specific currency, then the price will rise from A to B, provided the supply remains stable.
On the contrary, if the supply is increased (shift of the curve from S to S1), the price will decline
from A to C, provided the demand remains stable
The
exchange
rate
as
a
price
for
the
demand
and
supply
of
domestic
currency
Exchange rate E
S1
er1
D1
O
Quantity of Rs.
Exchange rate
S1
er1
S2
Depreciation
er2
D2
O
Quantity of Rs.
D1
Exchange rate
S1
S2
er1
Depreciation
er2
D2
O
Quantity of Rs.
D1
Exchange rate
S1
er1
D1
O
Quantity of Rs.
S1
Exchange rate
er3
er1
D3
D1
O
Quantity of Rs.
S1
Exchange rate
er3
Appreciation
er1
D3
D1
O
Quantity of Rs.
The theory is based on the law of one price, which argues that should a euro price of a
good be multiplied by the exchange rate ( /US$) then it will result in an equal price of
the good in US dollars.
In other words, if we assume that the exchange rate between the and US $ states at
1/1.2, then goods that cost 10 in the EU should cost US$ 12 in the United States.
Otherwise, arbitrage profits will occur.
However, it is finally the market that through supply and demand will force
accordingly the euro and US dollar prices to the equilibrium point.
Thus, the law of one price will be reinstated, as well as the purchase power parity
between the euro and US dollar.
The balance of payments approach is another method that explains what the factors are
that determine the supply and demand curves of a countrys currency.
As stated earlier, a currencys price depreciation or appreciation (the change in the value
of money), directly affects the volume of a countrys imports and exports and,
consequently, a likely fluctuation in the exchange rates can add to BOP discrepancies.
For example, a likely depreciation will increase the value of exports in home currency
terms (the larger the exports demand elasticity the greater the increase).
Conversely, the imports will become more expensive and their value will be reduced in
home currency (the larger the imports demand elasticity the greater the decrease).
Consequently, we can argue that unless the value of exports increases less than the value
of imports, the depreciation will improve the current account. More specifically, we can
finally assess the impact of the currencys depreciation on the current account only by
considering the price sensitivity of imports and exports.
Forward
Exchange Rate
Exchange Risk
Hedging &
Speculation
Case Study
If U.S. tastes for EU products increase, the U.S. demand for euros increases (the
demand curve shifts up), leading to a rise in the exchange rate (i.e., a depreciation
of the dollar). On the other hand, a lower rate of inflation in the U.S. than the EU
leads to U.S. products becoming cheaper for EU residents. This tends to increase
the U.S. supply of euros ( the supply curve shifts to the right) and causes a decline
in the exchange rate (i.e., an appreciation of the dollar). Or simply the expection
of a stronger dollar may lead to an appreciation of the dollar. In short, in a
dynamic and changing world, exchange rates frequently vary, reflecting the
constant change in the numerous economic forces simultaneously at work.
Hedging
Concept
It refers to the avoidance of a foreign exchange risk (or the covering of an
open position). Differences from Covering the Foreign Exchange Risk in the
Spot Market (deposit the money for the late use of payment and receipt fore
the interest rate)
Hedging usually takes place in the forward market, where no borrowing or
tying up of funds is required.
e.g. The importer could buy euros forward for delivery (and payment) in three
months at todays three-month forward rate. If the euro is at a three forward
premium of 4% per year, the importer will have to pay $ 101,000 in three months
for the 100,000 needed to pay for the imports.
Conclusion
A foreign exchange risk can also be hedged and an open position avoided in the futures or
options markets.
e.g. Suppose that an importer knows that he or she must pay 100,000 in three months and the
three-month forward rate of the pound is FR=$1/ 1. The importer could either purchase the
100,000 forward (in which case he or she will have to pay $100,000 in three months and
receive the 100,000) or purchase an option to purchase 100,000 in three months , say at $1/
1, and pay now the premium of , say, 1 percent (or$1,000 on the $100,000 option). If in three
months the spot rate of the pound is SR=$0.98/ 1, the importer would have to pay $100,000
with the forward contract, but could let the option expire unexercised and get the 100,000 at
the cost of only$98,000 on the spot market. In that case, the $1,000 premium can be regarded
as an insurance policy and the importer will save $2,000 over the forward contract.
In a word of foreign exchange uncertainty, the ability of traders and investors to hedge
greatly facilitates the international flow of trade and investments. Without hedging there
would be smaller international capital flows, less trade and specialization in production,
and smaller benefits from trade. (e.g. MNCs)
Speculation
Concept
It refers to the acceptance of a foreign exchange risk, or open position, in the hope of
making a profit. If the speculator correctly anticipates future changes in spot rate, he or
she makes a profit; otherwise, he or she incurs a loss. As in the hedging, speculation
can take place in the spot, forward, futures, or options markets - usually in the forward
market.
Speculation in Spot Market
If a speculator believes that the spot rate of a particular foreign currency will rise, he
or she can purchase the currency now and hold it on deposit in a bank for resale later; If
the speculator is correct and the spot rate does indeed rise, he or she earns a profit on
each unit of the foreign currency equal to the spread between the previous lower spot
rate at which he or she purchased the foreign currency and the higher subsequent spot
rate at which he or she resells it. Otherwise the speculator will bear the loss.
If the speculator believes that the spot rate will fall, he or she borrows the foreign
currency for three months, immediately exchanges it for the domestic currency at the
prevailing spot rate, and deposits the domestic currency in a bank to earn interest.
In both of the preceding examples, the speculator operated in the spot market and
either had to tie up his or her own funds or had to borrow to speculate.
Speculation in the Forward Market
If the speculator believes that the spot rate of a certain foreign currency will be higher
in three months than its present three-month forward rate, the speculator purchases a
specified amount of the foreign currency forward for delivery ( and payment ) in three
months. After three months, if the speculator is correct, he or she receives delivery of
the foreign currency at the lower agree forward rate and immediately resells it at the
higher spot rate, thus realizing a profit. Otherwise, the speculator will bear the loss.
Speculation in an Option
If the speculator believes that the foreign currency will depreciate, he or she could
have purchased an option to sell a specific amount of foreign currencies in three
months. If the speculator is correct, he or she will exercise the option, buy foreign
currency in the spot market and receive the payment by exercising the option and
earns the profit. Otherwise, he or she will bear the loss.
A Long Position & A Short Position
A Long Position
When a speculator buys a foreign currency on the spot, forward, or futures market, or
buys an option to purchase a foreign currency in the expectation of reselling it at a
higher futures spot rate, he or she is said to take a long position in the currency.
A Short Position
When the speculator borrows or sells forward a foreign currency in the expectation of
buying it at a future lower price to repay the foreign exchange loan or honor the
forward sale contract or option, the speculator is said to take a short position.