IFM Notes 1

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International Financial Management
Finance and Accounting (Christ (Deemed To Be University))
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INTERNATIONAL FINANCIAL MANAGEMENT (UNIT-1)

Meaning and Relevance of IFM:
International Financial Management is a well-known term in today’s world and it is

also known as international finance. It means financial management in an international
business environment. It is different because of the different currency of different
countries, dissimilar political situations, imperfect markets, diversified opportunity
sets. International financial management may be defined as management of financial
operations of different international activities of an organization.
International Financial Management came into being when the countries of the world
started opening their doors for each other. This phenomenon is well known by 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, multi-currency bonds, and international mutual funds.
International Finance is an important part of financial economics. It mainly discusses

the issues related with monetary interactions of at least two or more countries.
International finance is concerned with subjects such as exchange rates of currencies,
monetary systems of the world, foreign direct investment (FDI), and other important
issues associated with international financial management.
Like international trade and business, international finance exists due to the fact that
economic activities of businesses, governments, and organizations get affected by the
existence of nations. It is a known fact that countries often borrow and lend from each
other. In such trades, many countries use their own currencies. Therefore, we must
understand how the currencies compare with each other. Moreover, we should also
have a good understanding of how these goods are paid for and what is the
determining factor of the prices that the currencies trade at.
Note − The World Bank, the International Finance Corporation (IFC), the
International Monetary Fund (IMF), and the National Bureau of Economic Research
(NBER) are some of the notable international finance organizations.

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International Business: Globalization Overview
International financial management is a growing field with significant implications for

the economic relationship between countries, businesses, and the global economy as a
whole. Globalization has made a tremendous impact throughout the world in past few
years. The world has seen a tremendous increase in the global transactions and foreign
trade in recent years. International financial activity requires active management
practices and tools. International financial management combines the fields of
international finance and financial management. International finance refers to the field
of economics that involves exchange rates, foreign investment, and international trade.
Financial management refers to a division of management responsible for both
resource management and finance operations. International financial management
concerns multinational corporations as whole entities and involves cross-disciplinary
decision-making. International financial management is a holistic endeavor involving
international financial planning, financial control, and financial decision-making.
Multinational corporations rely on international financial management to achieve the

goals of creating a competitive advantage in the global marketplace and maximizing
shareholder profits. Traditional models of corporate financial management are
changing as a result of new technological, business, and market environments.
International financial managers now manipulate and combine unbundled financial
products, such as futures, swaps, derivatives, etc, to meet the needs of individual
clients. Common concerns for international financial managers include the following:
Exchange rate fluctuations, forecasting efficiency, transactions exposure, long-term
financing, direct foreign investment, futures and options, country risk, international
working capital management, transfer pricing, and economic exposure.
The Global Economy
International financial management is growing in importance as international financial

activity and global markets become increasingly common. Global markets are
characterized by an increasing mobility in capital, research and design processes,
production facilities, customers, and regulators. Global markets, created through socio-
economic changes, political revolutions, and new Internet and communication
technology, have no national borders. The modern trend of globalization, and resulting
shifts from centralized to market economies in much of the world, has created

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opportunities for increased trade, investment, business partnerships, and access to once
closed global markets.
Economic environments around the world are changing due to the forces of
globalization. Globalization is characterized by the permeability of traditional
boundaries of nations, culture, and economic market. The fundamental economic
forces and events influencing globalization around the world include the end of
communism; the shift from an economy based on natural resources to one based on
knowledge industries; demographic shifts; the development of a global economy;
increased trade liberalization; and advances in communication technology.
Business opportunities, including international investments and joint ventures, in the

global economy are increasingly tied to trade pacts. In addition, business opportunities
are resulting from privatization worldwide. Countries are privatizing many state-owned
industries and allowing foreign investors to purchase pieces of them through joint
ventures or local operations so that they can participate in these projects.
Emerging markets, often occurring in countries experiencing political upheaval, will

continue to increase in the expanding global market. Businesses, participating in the
new global economy, will continue to seek out new manufacturing and sales
opportunities in foreign markets and countries.
Difference between MNC and TNC
An international company is an organization that has business operations in several

markets across the globe. A multinational corporation (MNC) is an organization that
owns or controls production of goods or services in one or more countries other than
their home country. A transnational corporation (TNC) is a commercial enterprise that
operates substantial facilities, (invest in foreign operations) does business in more than
one country and does not consider any particular country its national home.
Features (characteristics) of MNC’s
(i) Huge Assets and Turnover:
Due to operations on a global basis, MNCs have huge physical and financial assets.
This also results in huge turnover (sales) of MNCs. In fact, in terms of assets and
turnover, many MNCs are bigger than national economies of several countries.

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(ii) International operations through a Network of Branches:
MNCs have production and marketing operations in several countries; operating

through a network of branches, subsidiaries and affiliates in host countries.
(iii) Unity of Control:
MNCs are characterized by unity of control. MNCs control business activities of their
branches in foreign countries through head office located in the home country.
Managements of branches operate within the policy framework of the parent
corporation.
(iv) Mighty Economic Power:
MNCs are powerful economic entities. They keep on adding to their economic power
through constant mergers and acquisitions of companies, in host countries.
(v) Advanced and Sophisticated Technology:
Generally, a MNC has at its command advanced and sophisticated technology. It

employs capital intensive technology in manufacturing and marketing.
(vi) Professional Management:
A MNC employs professionally trained managers to handle huge funds, advanced

technology and international business operations.
(vii) Aggressive Advertising and Marketing:
MNCs spend huge sums of money on advertising and marketing to secure international
business. This is, perhaps, the biggest strategy of success of MNCs. Because of this
strategy, they are able to sell whatever products/services, they produce/generate.
(viii) Better Quality of Products:
A MNC has to compete on the world level. It, therefore, has to pay special attention to
the quality of its products.

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Advantages of MNCs
(i) Employment Generation:
MNCs create large scale employment opportunities in host countries. This is a big
advantage of MNCs for countries; where there is a lot of unemployment.
(ii) Automatic Inflow of Foreign Capital:
MNCs bring in much needed capital for the rapid development of developing
countries. In fact, with the entry of MNCs, inflow of foreign capital is automatic. As a
result of the entry of MNCs, India e.g. has attracted foreign investment with several
million dollars.
(iii) Proper Use of Idle Resources:
Because of their advanced technical knowledge, MNCs are in a position to properly

utilise idle physical and human resources of the host country. This results in an
increase in the National Income of the host country.
(iv) Improvement in Balance of Payment Position:
MNCs help the host countries to increase their exports. As such, they help the host
country to improve upon its Balance of Payment position.
(vi) Technical Development:
MNCs carry the advantages of technical development 10 host countries. In fact, MNCs
are a vehicle for transference of technical development from one country to another.
Because of MNCs poor host countries also begin to develop technically.
(vii) Managerial Development:
MNCs employ latest management techniques. People employed by MNCs do a lot of

research in management. In a way, they help to professionalize management along
latest lines of management theory and practice. This leads to managerial development
in host countries.

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(viii) End of Local Monopolies:
The entry of MNCs leads to competition in the host countries. Local monopolies of
host countries either start improving their products or reduce their prices. Thus MNCs
put an end to exploitative practices of local monopolists. As a matter of fact, MNCs
compel domestic companies to improve their efficiency and quality.
(ix) Improvement in Standard of Living:
By providing super quality products and services, MNCs help to improve the standard
of living of people of host countries.
(x) Promotion of international brotherhood and culture:
MNCs integrate economies of various nations with the world economy. Through their
international dealings, MNCs promote international brotherhood and culture; and pave
way for world peace and prosperity.
Limitations of MNC’s
(i) Danger for Domestic Industries:
MNCs, because of their vast economic power, pose a danger to domestic industries;
which are still in the process of development. Domestic industries cannot face
challenges posed by MNCs. Many domestic industries have to wind up, as a result of
threat from MNCs. Thus MNCs give a setback to the economic growth of host
countries.
(ii) Repatriation of Profits:
(Repatriation of profits means sending profits to their country).
MNCs earn huge profits. Repatriation of profits by MNCs adversely affects the foreign
exchange reserves of the host country; which means that a large amount of foreign
exchange goes out of the host country.
(iii) No Benefit to Poor People:
MNCs produce only those things, which are used by the rich. Therefore, poor people of
host countries do not get, generally, any benefit, out of MNCs.

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(iv) Danger to Independence:
Initially MNCs help the Government of the host country, in a number of ways; and
then gradually start interfering in the political affairs of the host country. There is, then,
an implicit danger to the independence of the host country, in the long-run.
(v) Disregard of the National Interests of the Host Country:
MNCs invest in most profitable sectors; and disregard the national goals and priorities
of the host country. They do not care for the development of backward regions; and
never care to solve chronic problems of the host country like unemployment and
poverty.
(vi) Misuse of Mighty Status:
MNCs are powerful economic entities. They can afford to bear losses for a long while,
in the hope of earning huge profits, once they have ended local competition and
achieved monopoly. This may be the dirty strategy of MNCs to wipe off local
competitors from the host country.
(vii) Careless Exploitation of Natural Resources:
MNCs tend to use the natural resources of the host country carelessly. They cause
rapid depletion of some of the non-renewable natural resources of the host country. In
this way, MNCs cause a permanent damage to the economic development of the host
country.
(viii) Selfish Promotion of Alien Culture:
MNCs tend to promote alien culture in host country to sell their products. They make
people forget about their own cultural heritage. In India, e.g. MNCs have created a
taste for synthetic food, soft drinks etc. This promotion of foreign culture by MNCs is
injurious to the health of people also.
(ix) Exploitation of People, in a Systematic Manner:
MNCs join hands with big business houses of host country and emerge as powerful
monopolies. This leads to concentration of economic power only in a few hands.

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Gradually these monopolies make it their birth right to exploit poor people and enrich
themselves at the cost of the poor working class.
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 −
a) 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.
b) 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.
c) 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.
d) 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.
e) 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.
f) 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.
g) 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.
h) International finance organizations, such as IMF, the World Bank, etc., provide
a mediators’ role in managing international finance disputes.
Characteristic features of IFM
International Finance is a distinct field of study and certain features set it apart from
other fields. Compared to domestic financial management, international finance has
some important distinguishing features below.

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a) Foreign exchange risk
An understanding of foreign exchange risk is essential for managers and investors in

the modern day environment of unforeseen changes in foreign exchange rates. In a
domestic economy this risk is generally ignored because a single national currency
serves as the main medium of exchange within a country. When different national
currencies are exchanged for each other, there is a definite risk of volatility in foreign
exchange rates. The present International Monetary System set up is characterized by a
mix of floating and managed exchange rate policies adopted by each nation keeping in
view its interests. In fact, this variability of exchange rates is widely regarded as the
most serious international financial problem facing corporate managers and policy
makers.
At present, the exchange rates among some major currencies such as the US dollar,
British pound, Japanese yen and the euro fluctuate in a totally unpredictable manner.
Exchange rates have fluctuated since the 1970s after the fixed exchange rates were
abandoned. Exchange rate variation affect the profitability of firms and all firms must
understand foreign exchange risks in order to anticipate increased competition from
imports or to value increased opportunities for exports.
b) Political risk
Another risk that firms may encounter in international finance is political risk. Political
risk ranges from the risk of loss (or gain) from unforeseen government actions or other
events of a political character such as acts of terrorism to outright expropriation of
assets held by foreigners. MNCs must assess the political risk not only in countries
where it is currently doing business but also where it expects to establish subsidiaries.
The extreme form of political risk is when the sovereign country changes the ‘rules of
the game’ and the affected parties have no alternatives open to them. Thus, political
risk associated with international operations is generally greater than that associated
with domestic operations and is generally more complicated.
c) Expanded opportunity sets
When firms go global, they also tend to benefit from expanded opportunities which are
available now. They can raise funds in capital 7 markets where cost of capital is the

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lowest. In addition, firms can also gain from greater economies of scale when they
operate on a global basis.
d) Market imperfections
The final feature of international finance that distinguishes it from domestic finance is
that world markets today are highly imperfect. There are profound differences among
nations’ laws, tax systems, business practices and general cultural environments.
Imperfections in the world financial markets tend to restrict the extent to which
investors can diversify their portfolio. Though there are risks and costs in coping with
these market imperfections, they also offer managers of international firm’s abundant
opportunities.
Nature and scope of International Financial Management: -
It has already been mentioned that IFM is concerned with the financial aspects of
international business. In other words, international financial management deals with
the financial decisions taken in the area of international business. It helps in taking the
correct financial decisions so that the maximum gain may be derived from international
business. The nature and scope of IFM are:
1. Mode of International Business: - Mode of international business is:

 Foreign Trade: - The oldest form of international business is foreign trade. A
firm imports its necessary inputs from the cheapest source, while it exports its
output to different countries in order to earn maximum Foreign exchange. In this
case, no overseas manufacturing is involved.
 Licensing: - Another mode of international business that is licensing. When a
firm lacks capital and detailed knowledge about a foreign market, it allows its
technology, patent, trademark and other proprietary advantages to be used for a
fee by licensee or technology importing firm.
 Management contracting: - The third mode is known as management contracts.
In this mode, the company sells abroad a particular resource, like management
skills. The contract is meant for a given number of years during which the seller
of management skills manage affairs of the company located in the host country
for a specific fee.
 Joint Venture: - Joint venture are the forth mode. They represent a partnership
agreement which the venture is owned jointly by the international company and

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a company of the host country. Naturally, the joint venture allows the two firms
to apply their respective comparative advantages in a given project.
2. Foreign Exchange market: - The study of foreign exchange market forms as an

important area of IFM. The importers of goods have normally to pay for the import in
convertible currencies which they buy with their own currency. The exporter converts
their exports proceeds into their currency. Currency arbitrage is also quite common in
the foreign exchange market; the arbitrageurs take advantage of this fact. Forward
trading is a common feature in the foreign exchange market. Speculator makes profit
out of them. IFM covers the study of the distinguishing features of operations in these
different segments of the foreign exchange market.
3. Exchange rate determination: - The behavior and determination of exchange rate is

another segment of the study of IFM. The question of day to day exchange rate
determination does not arise in a fixed- rate regime but in a system of Floating
exchange rate, this question is very important. The rate depends upon the forces of
supply and demand that in turn depend upon the macroeconomic variables. Such as
interest rate, inflation rate etc.
4. Exchange rate risk and its management: - Change in the exchange rate consequent
upon the changes in macroeconomic fundamentals impact international business in the
form of gain and losses. The gain and loss arising on the accounts of unanticipated
exchange rate changes is known as Foreign exchange exposure.
5. MNCs Investment decisions: - When a company innovates a specific technology and

its product is mature in the markets aboard or when the company wants to reap the
location advantage in a foreign country, it sets up an affiliate there. Whatever the
motivation behind foreign investment of foreign manufacturing, the company evaluates
the cash inflow and out flow during the life of the project and makes investment only
when the net present value of cash inflows is positive. Behind it takes into account the
foreign exchange risk and the political risk involved. IFM thus studies the
 Different theories of overseas
 The various strategies of Capital budgeting decisions
 Evaluation of foreign
 Political risks pertaining to overseas investment

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6. International working capital Decisions: – when a foreign operation begins, the

parent company evaluates different sources of working capital so that the cost of
financing is the cheapest. In this context, an international company maintains an edge
over a domestic company so far as it can easily reach the international financial market
or can siphon resources from one subsidiary to another. When targeting sources of
funds, it has also to decide the size of current assets because these facts have a close
link with the cost of production and the overall profitability of the firm. IFM helps in
taking a correct decision regarding the size of working capital and suggest a
mechanism for its management. It also deals with how foreign trade is financed.
7. Financing decisions of MNCs: – Any investment needs rising of funds. The MNCs
take advantages of many innovations which have taken place in the international
financial market and IFM guides them on how to take advantages of these. It deals with
how different instruments are issued to raise funds and how swap are used for
minimizing the cost of funds. The nature and management of interest rate exposure to
form a part of the study of IFM.
8. International Accounting: – International accounting forms an integral part of IFM.

It analysis the following:
 Techniques for consolidation of financial statements of various affiliates.
 Internal audit
 International financing reporting
 Transfer pricing.
Risk Involved in an International Business
a) Country Risk
Weigh the benefits of your company doing business abroad against the potential
pitfalls. Poor infrastructure such as roads, bridges and telecommunications networks
can make it expensive to operate a business in another country. Economic conditions
such as high unemployment or a largely unskilled labor force can be barriers to entry.
Rogue nations may have untapped potential, but may also pose risks such as terrorism,
internal conflict and civil unrest. Anti-foreign sentiment among citizens, workers and
government officials may also make doing business abroad especially challenging.
Other country risks include crime and corruption.

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b) Political Risk
Determine the political climate of the country you hope to enter. An unstable or
ineffective government will be unable to protect your business interests. With a lack of
a strong foreign trade policy, your business will have to go through the nuances of
allying with government officials and go with their power. An incoming government
may not be business-friendly, and may decide to increase tariffs or impose quotas.
c) Regulatory Risk
A sudden change in trade laws or a poor legal system exposes your business to
regulatory risk. For example, a country without clearly defined intellectual property
laws make it difficult for foreign software companies to protect their investments.
Changes in banking laws may limit your company's ability to repatriate money to your
home country or may limit access to funding.
d) Currency Risk
Fluctuations of a foreign country's currency can diminish profits when converting back
to the home currency. Analyze the risk and rewards of making an investment in
another country. The currencies of stable governments are less volatile than those of
less-developed countries. Hedging strategies could mitigate some of the currency risk;
however, your business is still at the mercy of the vagaries of the local currency
market. Sudden changes in monetary policy will also affect currency rates.
International Trade Association
If you are planning to do business overseas, contact the local office of the International
Trade Association, or ITA, in your state. The ITA is one of many agencies within the
U.S. Department of Commerce and is responsible for providing small and medium-
sized businesses with customs and trade facilitation support in foreign markets. The
ITA has Commercial Trade Service professionals in nearly 80 countries.
Differences between IFM and Domestic Financial Management
International finance is different from domestic finance in many aspects and first and
the most significant of them is foreign currency exposure. There are other aspects such
as the different political, cultural, legal, economical, and taxation environment.

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International financial management involves a lot of currency derivatives whereas such

derivatives are very less used in domestic financial management.
Following are the major differences:
1. Exposure to Foreign Exchange:

The most significant difference is of foreign currency exposure. Currency
exposure impacts almost all the areas of an international business starting from
your purchase from suppliers, selling to customers, investing in plant and
machinery, fund raising etc. Foreign exchange risk (exposure) refers to the risk of
fluctuating prices of currency which has the potential to convert a profitable deal
into a loss making one. Foreign exchange risk also exists when the foreign
subsidiary of a firm maintains financial statements in a currency other than the
reporting currency of the consolidated entity.
2. 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.
For example, political decisions by governmental leaders about taxes, currency
valuation, trade tariffs or barriers, investment, wage levels, labor laws,
environmental regulations and development priorities, can affect the business
conditions and profitability. Similarly, non-economic factors can affect a
business. For example, political disruptions such as terrorism, riots, coups, civil
wars, international wars, and even political elections that may change the ruling
government, can dramatically affect businesses’ ability to operate.
3. Macro Business Environment:

An international business is exposed to altogether a different economic and
political environment. All trade policies are different in different countries.
4. Legal And Tax Environment:

The other important aspect to look at is the legal and tax front of a country. The
International finance manager will look at the taxation structure to find out
whether the business which is feasible in his home country is workable in the
foreign country or not.

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5. The Different Group Of Stakeholders:

It is not only the money which along matters, there are other things which carry
greater importance viz. the group of suppliers, customers, lenders, shareholders
etc. A business is driven by these stakeholders and keeping them happy is all you
need.
6. Different Standards of Reporting:

If the business has a presence in say US and India, the books of accounts need to
be maintained in US GAAP and IGAAP.
7. Foreign Exchange Derivatives:

Since, it is inevitable to expose to the risk of foreign exchange in a multinational
business. Knowledge of forwards, futures, options and swaps is invariably
required.
8. Capital Management:
In an MNC, the financial managers have ample options of raising the capital. A
number of options create more challenge with respect to the selection of the right
source of capital to ensure the lowest possible cost of capital.
9. 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.
International Business Activities
The volume of international business has seen tremendous growth in recent years. The
effect of globalization in industry and services is making the nations to be more open
and adaptable to foreign investment. The inflow of foreign investment is very
important for the economic development of a country. The inflows from foreign
investment can be divided into two categories:
1) Foreign Direct Investments (FDI) is investments made for the purpose of

actively controlling property assets or companies located in host countries.

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2) Foreign Portfolio Investments (FPI) is purchases of foreign financial assets for a

purpose other than control. It is interchangeably used with FII.
FDI (Foreign Direct Investment) is one of the most important sources of capital market
and links the host country with the global markets. The potential of FDI is determined
by factors like access to resource, low production costs, access to export markets,
geographic proximity etc. It also generates increased employment opportunities and in
turn enhances labour productivity. In addition, FDI also brings with it new technology
and management techniques which helps in judiciously utilizing the scarce resources
and provides improved quality products at lower prices. FDI is permitted in India in the
forms of investments through financial collaborations, joint ventures, technical
collaborations, through capital markets etc. However, FDI is not permitted (restricted
to) to sectors like arms and ammunition, atomic energy, railway transport, coal, mining
of iron ore, manganese ore, gold, diamonds, copper etc.
FPI (Foreign Portfolio Investment) is a grouping of assets such as stocks, bonds,

and cash equivalents. Portfolio investments are held directly by an investor or managed
by financial professionals. In economics, foreign portfolio investment is the entry
of funds into a country where foreigners deposit money in a country's bank or make
purchases in the country’s stock and bond, sometimes for speculation. The foreign
portfolio investment which consists of securities and other foreign financial assets
(held passively foreign investor) does not provide them with direct ownership of the
financial assets. Foreign portfolio investments can be made by individuals, companies,
or even governments in international countries. This type of investment is a way for
investors to diversify their portfolio with an international advantage.
FII (Foreign Institutional Investor) is an investor of group of investors who bring FPIs.
Institutional investors include hedge funds, insurance companies, pension funds and
mutual funds. They participate in the secondary market of economy.
International Business Methods

There are number of ways to internationalizing the business. Business can choose
among these business methods:
1) Importing & Exporting

Imports: a good or service brought into one country from another.
Exports: a good or service produced in one country then get marketed to other country.

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Import-export is the most fundamental and the largest international business activity,
and it is often the first choice when the businesses decide to expand abroad as it is the
easiest way to enter the market with a small outlay of capital.
2) Licensing
Licensing is one of other ways to expand the business internationally. Licensing is the
arrangement between a firm called licensor, allows another one to use its intellectual
property such as brand name, copy right, patent, technology, trademark and so on for a
specific period of time. The licensor gets benefits in term of the royalty. The company
may choose to sell the products under the licensing when the domestic production costs
are too high, strict government regulations, or the company wants to sell and produce
standardized products everywhere.
3) Franchising
Franchising is closely related to licensing. Franchising is a parent company (franchiser)

gives right to another company (franchisee) to do business using the franchiser’s name
and products in a prescribed manner. Franchising is different from the licensing in
terms of the franchisees have to follow much stricter guidelines. Moreover, licensing is
more about the manufacturers while franchising is more popular with restaurants and
rental services. For example: McDonald, KFC etc.
4) Strategic Partnership & Joint Venture
A strategic partnership or alliance is a positive aspect of the cooperation of two or

more companies in different countries are joined together for mutual gain. A joint
venture is a special type of strategic alliance, where the partners across globe
collectively fund a company to produce goods and services. The cooperation between
the companies allows them to share the production cost, technologies, development,
and sales networks. The resources will be pooled to mutual advantages and put the
companies in win-win situations. For example, Motorola and Toshiba joined a strategic
partnership to develop manufacturing processes for microprocessors.
5) Management Contract
A management contract is an agreement between two companies whereby one

company provides managerial assistance, technical expertise and specialized services

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to the second company for a certain period of time in return for monetary
compensation. For example, Schools or office buildings or malls etc have on-site
cafeterias / restaurants.
6) Acquisitions of existing operations
Firms frequently acquire other firms in foreign countries as a means of penetrating

foreign markets. Acquisitions allow firms to have full control over their foreign
businesses and to quickly obtain a large portion of foreign market share.
For example: Cadbury Schweppes has grown mainly through acquisitions in recent
years including Wedel chocolate (Poland, 1999), Hollywood chewing gum (France,
2000), a buyout of minority shareholders of Cadbury India (2002), etc and clearly they
were seeking synergies by being dominant in their business.
An acquisition of an existing company is a quick way to grow. An MNC that grows in

this way also partly protects itself from adverse actions from the host government of
the acquired company. The risk is that too much has to be paid for the acquisition, also
that there are unforeseen problems with the acquired company.
Some firms engage in partial international acquisitions in order to obtain a stake in

foreign operations. This requires a smaller investment than full international
acquisitions and therefore exposes the firm to less risk. On the other hand, the firm will
not have complete control over foreign operations that are only partially acquired.
7) Establishing new foreign subsidiaries
Firms can also penetrate foreign markets by establishing new operations in foreign
countries to produce and sell their products. This method requires a large investment.
Establishing new subsidiaries may be preferred to foreign acquisitions because the
operations can be tailored exactly to the firm's needs. Development will be slower,
however, in that the firm will not reap any rewards from the investment until the
subsidiary is built and a customer base established.
Motivation Factors for International Business
There are numerous reasons why to proceed internationally, however the objective of
every company for going international is to expend its business, searching new market

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and expend its customer base. There are several reasons listing below for entering in
international market:
a) Growth and Profitability –

A lot of companies turn to global markets for growth. Introducing new products
internationally can broaden their customer base, sales and revenue.
b) Economics of Scale –
Expanding size and scope of markets help to achieve economies of scale. International
approaches give economies of scale while sharing of costs and risks between markets.
Economies of scale occur when the unit cost of a product declines as production
volume increases.
c) Spreading R&D costs –

Through spreading the marketplace, a firm rapidly recovers the cost incurred in R&D.
it is especially true with regard to products including higher cost associated with R&D.
As result of the large marketplace and also due to larger coverage of the right market
segments in international markets, it facilitates speedy recovery of such costs.
d) Risk Diversification –
Several companies move worldwide so that they can diversify. Selling products in
numerous countries reduces the company's exposure to economic as well as political
instability within the country.
e) Uniqueness of Product or Services –

The product with distinctive attributes isn’t likely to meet competition in the abroad
markets and enjoy massive options throughout worldwide marketplaces.
f) Resources and Ideas –

Due to unavailability of resources in domestic country or at better competitive rate
companies turn into global market. Also companies proceed internationally to collect
the different ideas in the different lifestyle of various countries as well as to broaden
their workforce.
g) Employees –
All organization wants skilled and well trained employees, as a result company goes to
worldwide marketplace to find alternate source of the labor at lower cost.

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Input Markets and Output Markets
An input / factor market is a market place for the services of a factor of production. A
factor market facilitates the purchase and sale of services of factors of production,
which are inputs like labor, capital, land and raw materials that are used by a firm to
make a finished product. A factor market is distinct from the goods and services
market, which is the market for finished products or services.
In economics, factors of production, resources, or inputs are what are used in the
production process to produce output – that is, finished goods and services. The
utilized amounts of the various inputs determine the quantity of output according to the
relationship called the production function. There are three basic resources or factors of
production: land, labor, and capital. The factors are also frequently labeled "producer
goods or services" to distinguish them from the goods or services purchased by
consumers, which are frequently labeled "consumer goods".
Output (product market) in economics is the "quantity of goods or services produced in

a given time period, by a firm, industry or country”, whether consumed or used for
further production.
THE CIRCULAR FLOW

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BALANCE OF PAYMENTS (UNIT-2)
The balance of payments (also known as balance of international payments and

abbreviated as BOP) of a country is the record of all economic transactions between
the residents of the country and the rest of world in a particular period of time (over a
quarter of a year or more commonly over a year). The balance of payments is a
summary of all monetary transactions between a country and rest of the world. These
transactions are made by individuals, firms and government bodies. Thus the balance
of payments includes all external visible and non-visible transactions of a country. It is
an important aspect to be studied, especially in international financial management, for
a few reasons like:
First, the balance of payments provides detailed information concerning the demand
and supply of a country's currency. For example, if Kenya imports more than it
exports, then this means that the quantity supplied of Kenyan shilling by the domestic
market is likely to exceed the quantity demanded in the foreign exchanging
market, ceteris paribus (Latin – other things being equal). One can thus infer that
the Kenyan shilling would be under pressure to depreciate against other currencies. On
the other hand, if Kenya exports more than it imports, then the Kenyan shilling would
be likely to appreciate.
Second, a country's balance of payments data may signal its potential as a business
partner for the rest of the world. If a country is grappling with a major balance of
payments difficulty, it may not be able to expand imports from the outside world.
Instead, the country may be tempted to impose measures to restrict imports and
discourage capital outflows in order to improve the balance of payments situation. On
the other hand, a country with a significant balance of payment surplus would be more
likely to expand imports, offering marketing opportunities for foreign enterprises, and
less likely to impose foreign exchange restrictions.
Third, balance of payments data can be used to evaluate the performance of the
country in international economic competition. Suppose a country is experiencing trade
deficits year after year. This trade data may then signal that the country's domestic
industries lack international competitiveness.
Thus, Balance of Payment account keeps the systematic records of all the economic
transactions (visible and non-visible) both of a country with all other countries in the

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given or specific periods. In BOP account, all the receipts from abroad are recorded as
credit and all the payments to abroad as debit. Since, the account is maintained by
double entry book keeping system, it shows the balance of payment account is always
balanced. Sources of funds for a nation, such as exports or the receipts of
loans and investments, are recorded as positive or surplus items. Uses of funds, such as
for imports or to invest in foreign countries, are recorded as negative or deficit items.
Definition: The balance of payments is a statement of all transactions made between

entities in one country and the rest of the world over a defined period of time, such as a
quarter or a year.
In the words of C. B. Kindleberger: “The balance of payments of a country is a sys-

tematic record of all economic transactions between the residents of the reporting and
the residents of the foreign countries during a given period of time.”
Here, by ‘residents’ it means individuals, firms and government. By all economic

transactions we mean transactions of visible goods (merchandise) and invisible goods
(services), assets, gifts, etc. In other words, BOP shows how money is spent abroad
(i.e. payments) and how money is received domestically (i.e., receipts). Thus, a BOP
account records all payments and receipts arising out of all economic transactions.
The International Monetary Fund defines BOP as a “statistical statement that

subsequently summarizes, for a specific time period, the economic transactions of an
economy with the rest of the world.”
The basic types of economic transactions (economic value) can be:
1. Purchase or sale of goods or services with a financial quid pro quo (reciprocal
exchange). One real and one financial transfer.
2. Purchase or sale of goods or services in return for goods or services (or barter
transaction). Two real transfers.
3. An exchange of financial items, e.g. purchase of foreign securities with payment
in cash or by cheque. Two financial transfers.
4. A unilateral gift in kind. One real transfer.
5. A unilateral financial gift. One financial transfer.

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Difference between balance of trade and balance of payment
Balance of trade is the difference between exports of goods and imports of

goods. Balance of payments is the difference between inflow of foreign exchange and
outflow of foreign exchange.
Balance of Payments Manual: The Balance of Payments manual presents revised and
updated standards for concepts, definitions, and classifications for international
accounts statistics. These standards are used globally to compile comprehensive and
comparable data. The sixth edition is the latest in a series that the IMF began in 1948.
It is the result of widespread consultation and provides elaboration and clarification
requested by users. In addition, it focuses on developments such as globalization,
financial market innovation, and increasing interest in balance sheet analysis. Also it
provides a set of rules to resolve any ambiguities.
In India the BOP manual is prepared and released by Reserve Bank of India. It has
adopted the IMF manual and the latest being released in September 2010. It contains
the concepts, definitions, international investment position, services, income, transfers,
capital and financial account, foreign exchange reserves etc. The manual helps as a
guide for compiling global statistical data.
Reasons for a country to have Surplus in their BOP: It may be due to:
(i) Developmental activities (ii) Low rate of inflation (iii) No Cyclical fluctuations (iv)
Export of Services (v) Political stability (vi) Change in tastes, preferences etc.
Why is continuous fiscal deficit a danger to a country's economic position?
Fiscal deficits arise whenever a government spends more money than it brings in
during the fiscal year. This imbalance, sometimes called the current accounts deficit or
the budget deficit, is common among contemporary governments all over the world.
Fiscal Deficit shows that total debt generated by the government to finance the total
budget expenditure after exhausting all options for financing its expenditure. Fiscal
Deficit is justified as long as the expenditures are being incurred to finance activities
leading to creation of national asset. High Fiscal deficits become a matter of worry, for,
if incurred year after year, they cumulatively create a huge debt for the government.

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Government spending, inflation and lower revenue are among some of the main factors
that point to fiscal deficit. The cynical (self centered and not sincere) nature of fiscal
deficit not only hampers the growth of the country but also the government’s economic
management abilities.
Balance of Payments Accounting (Debits and Credits)
Like other accounting statements, the BOP conforms to the principle of double entry
bookkeeping. BOP is neither an income statement nor a balance sheet. It is sources of
funds and uses of funds statement that reflects changes in assets, liabilities and net
worth during a specified period of time. In the context of international transactions,
sources of funds include export of goods and services, investment and interest
earnings, unilateral transfers received from abroad and loans from foreigners. Uses of
funds include imports of goods and services, dividends paid to foreign investors,
transfer payments abroad, loans to foreigners and increase in reserve assets. In
accordance with the principle of double entry, sources and uses should match.
A country earns foreign exchange on some transactions and expends foreign exchange
on others when it deals with the rest of the world. Credit transactions are those that
earn foreign exchange and are recorded in the BOP with a plus (+) sign. Selling either
real or financial assets or services to non-residents is a credit transaction. For example,
the export of Indian made goods, borrowing from abroad, sale to a foreign resident of a
service etc. are credit transactions.
Transactions that expend or use up foreign exchange are recorded as Debits and are
entered with a minus (-) sign. Purchasing either real or financial assets or services from
non-residents is a debit transaction. For example, the import of goods or services from
foreign countries or purchase foreign services, foreign exchange is used and the entry
is recorded as debit transaction.
Credit Transactions (+) are those that involve the receipt of payment from foreigners
and the following are some of the important credit transactions:
a) Export of goods or services

b) Unilateral transfers (gifts) received from foreigners
c) Capital inflows

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Debit Transactions (-) are those that involve the payment of foreign exchange and the
following are some of the important debit transactions:
a) Import of goods or services

b) Unilateral transfers (gifts) made to foreigners
c) Capital outflows
Capital inflows can take either of the two forms:

a) An increase in foreign assets of the nation (foreign resident acquiring Indian
stock, foreign assets in India goes up and involves capital inflow)
b) A reduction in the nation’s assets abroad (Indian resident sells a foreign stock,
Indian assets decreases abroad and involves capital inflow)
Capital outflows can take either of the two forms:

a) A reduction in foreign assets of the nation (sale by a US firm of an Indian
subsidiary, reduces foreign assets in India and involves capital outflow)
b) An increase in the nation’s assets abroad (purchase of a UK financial asset by an
Indian resident, increases Indian assets abroad and involves capital outflow)
Components of BOP Accounts: According to the broad nature of the transactions

concerned, the BOP of a country is divided into two main parts: (i) the current account,
and the (ii) capital account. The other part is official reserve account.
(i) The Current account:

Current account refers to an account which records all the transactions relating to
export and import of goods and services and unilateral transfers during a given period
of time. Current account contains the receipts and payments relating to all the
transactions of visible items, invisible items and unilateral transfers.
The current account of BOP includes all transaction arising from trade in currently
produced goods and services, from income accruing to capital by one country and
invested in another and from unilateral transfers, both private and official.
The main components of Current Account are:
1. Export and Import of Goods (Merchandise Transactions or Visible Trade):

A major part of transactions in foreign trade is in the form of export and import of
goods (visible items). Payment for import of goods is written on the negative side
(debit items) and receipt from exports is shown on the positive side (credit items).

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Balance of these visible exports and imports is known as balance of trade (or trade
balance). The valuation is on fob (free on board) basis.
2. Export and Import of Services (Invisible Trade):

It includes a large variety of non-factor services (known as invisible items) sold and
purchased by the residents of a country, to and from the rest of the world. Payments are
either received or made to the other countries for use of these services.
As these transactions are not recorded in the customs office unlike merchandise trade
we call them invisible items. It includes freights and fares of ships and planes,
insurance and banking charges, foreign tours and education abroad, expenditures on
foreign embassies, transactions out of interest and dividends on foreigners’ investment,
and so on. Services are generally of four kinds:
(a) Travel
(b) Shipping (Transportation),
(c) Banking, and
(d) Insurance.
Payments for these services are recorded on the negative side and receipts on the
positive side. The difference between merchandise trade and invisible trade (i.e., items
1 and 2) is known as balance of trade.
3. Unilateral or Unrequited Transfers to and from abroad (One sided Transactions):

Unilateral transfers include gifts, donations, personal remittances and other ‘one-way’
transactions. These refer to those receipts and payments, which take place without any
service in return. Receipt of unilateral transfers from rest of the world is shown on the
credit side and unilateral transfers to rest of the world on the debit side.
Unrequited transfers mean a voluntary transfer of money by a government in which

little or nothing is expected in return or no compensation is expected in return.
Examples of official unrequited transfers include foreign aid, debt forgiveness,
pension, military aid, subsidies etc. Transfers may be official or private.
4. Income receipts and payments to and from abroad:

This is another flow in current account that consists of two items namely, investment
income and compensation to employees. Investment income consists of interest,
dividends, rent and profits. For example, interest earned by a U.S. resident from the

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TELCO share (Indian company) is one kind of investment income that represents a
debit item here.
Current Account shows the Net Income – Current Account records all the actual
transactions of goods and services which affect the income, output and employment of
a country. So, it shows the net income generated in the foreign sector.
Balance on Current Account:

In the current account, receipts from export of goods, services and unilateral receipts
are entered as credit or positive items and payments for import of goods, services and
unilateral payments are entered as debit or negative items. The net value of credit and
debit balances is the balance on current account.
Structure of The current account in India’s BOP Statement:

A. Current Account Credits Debits Net
I. Merchandise
II. Invisibles (a + b + c)
(a) Services
(1) Travel
(2) Transportation
(3) Insurance
(4) Government not elsewhere classified
(5) Miscellaneous
(b) Transfers
(6) Official
(7) Private
(c) Income
(8) Investment Income
(9) Compensation to Employees
Total Current Account (I + II)
Difference between Balance of Trade and Current Account

Basis Balance of Trade (BOT) Current Account
a) Components Balance of trade includes only Current account records both
visible items visible and invisible items
b) Scope It is a narrow concept as it is It is a wider concept and it
only a part of current account includes BOT.

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(ii) The Capital account:
The capital account shows transactions relating to the international movement of

ownership of financial assets. It refers to cross-border movements in foreign assets like
shares, property or direct acquisitions of companies’ bank loans, government’s
securities, etc. Hence, capital account records export and import of capital from and to
foreign countries.
In other words, Capital account of BOP records all those transactions, between the
residents of a country and the rest of the world, which cause a change in the assets or
liabilities of the residents of the country or its government. It is related to claims and
liabilities of financial nature.
Capital Account is used to:

(i) Finance deficit in current account; or
(ii) Absorb surplus of current account.
Capital account is concerned with financial transfers. So, it does not have direct effect
on income, output and employment of the country.
The main components of capital account are:
1. Borrowings and lending’s to and from abroad: It includes:
A. All transactions relating to borrowings from abroad by private sector, government,

etc. Receipts of such loans and repayment of loans by foreigners are recorded on the
positive (credit) side.
B. All transactions of lending to abroad by private sector and government. Lending
abroad and repayment of loans to abroad is recorded as negative or debit item.
2. Investments to and from abroad: It includes:
A. Investments by rest of the world in shares of Indian companies, real estate in India,
etc. Such investments from abroad are recorded on the positive (credit) side as they
bring in foreign exchange.
B. Investments by Indian residents in shares of foreign companies, real estate abroad,
etc. Such investments to abroad be recorded on the negative (debit) side as they lead to
outflow of foreign exchange.

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3. Short-term capital flows:
Capital flows represent the third category of capital account and represent claims with
a maturity of less than one year. Such claims include deposits, short-term loans, short-
term securities, money market investments and so on. For example, if the interest rate
rises in India, with other variables remaining constant, India will experience capital
inflows as investors would like to deposit or invest in India to take advantage of the
higher interest rate.
Balance on Capital Account:
The transactions, which lead to inflow of foreign exchange (like receipt of loan from
abroad, sale of assets or shares in foreign countries, etc.), are recorded on the credit or
positive side of capital account. Similarly, transactions which lead to outflow of
foreign exchange (like repayment of loans, purchase of assets or shares in foreign
countries, etc.) are recorded on the debit or negative side. The net value of credit and
debit balances is the balance on capital account.
[In this connection, the concepts of capital exports and capital imports require little
elaboration. Suppose, a US company purchases a firm operating in India. This sort of
foreign investment is called capital import rather than capital export. India acquires
foreign currency after selling the firm to a US company. As a result, India acquires
purchasing power abroad. That is why this transaction is included in the credit side of
India’s BOP accounts. In the same way, if India invests in a foreign country, it is a
payment and will be recorded on the debit side. This is called capital export. Thus,
India earns foreign currency by exporting goods and services and by importing capital.
Similarly, India releases foreign currency by importing visibles and invisibles and
exporting capital.]
(iii) The Official Reserve Account:
Official reserves are government owned assets and hence foreign exchange reserves are
the financial assets of the government held in the central bank. The official reserve
account represents only purchases and sales by the central bank of the country (e.g. the
RBI). The changes in the official reserves are necessary to account for the deficit or
surplus in the BOP. For example, if a country has a BOP deficit, the central bank will
have to either run down its official reserve assets such as gold, foreign exchange etc or

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borrow fresh from foreign central bank. So, any withdrawal from the reserves is
recorded on the positive (credit) side and any addition to these reserves is recorded on
the negative (debit) side.
Structure of the Capital account in India’s BOP Statement:

B. Capital Account Credits Debits Net
I. Foreign Investments (a + b)
(a) In India
(1) Direct
(2) Portfolio
(b) Abroad
II. Loans (a + b + c)
(a) External assistance
(1) By India
(2) To India
(b) Commercial borrowings (MT and LT)
(1) By India
(2) To India
(c) Short term to India
III. Banking capital (a + b)
(a) Commercial Banks
(1) Assets
(2) Liabilities
(3) Non-resident deposits
(b) Others
IV. Rupee Debt Service
V. Other Capital
Total Capital Account (I to V)
Now we can summarize the BOP data:
Current account balance + Capital account balance + Reserve balance = Balance of

Payments. When expressed as a formula it is:
(X – M) + (CI – CO) + FOREX = BOP
Where, X is exports, M is imports,
CI is capital inflows, CO is capital outflows,
FOREX is foreign exchange reserve balance.

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What's the difference between the current account and the capital account?
The balance of payments of a country contains two accounts: current and capital.
The current account records exports and imports of goods and services as well
as unilateral transfers, whereas the capital account records purchase and sale
transactions of foreign assets and liabilities during a particular year.
What is Disequilibrium in Balance of Payment?
Though the credit and debit are written balanced in the balance of payment account, it
may not remain balanced always. Very often, debit exceeds credit or the credit exceeds
debit causing an imbalance in the balance of payment account. Such an imbalance is
called the disequilibrium. Disequilibrium may take place either in the form of deficit or
in the form of surplus.
Disequilibrium of deficit arises when our receipts from the foreigners fall below our
payment to foreigners. It arises when the effective demand for foreign exchange of the
country exceeds its supply at a given rate of exchange. This is called an 'unfavourable
balance'.
Disequilibrium of surplus arises when the receipts of the country exceed its payments.
Such a situation arises when the effective demand for foreign exchange is less than its
supply. Such a surplus disequilibrium is termed as 'favourable balance'.
Types of Disequilibrium in Balance of Payments
The main types of disequilibrium in the balance of payments are:
1. Cyclical Disequilibrium:
When disequilibrium is caused due to the changes in trade cycles, it is termed as
cyclical disequilibrium. It is possible that different phases of trade cycles like
depression, prosperity, boom, recession, etc, may disturb terms of trade and cause
disequilibrium in balance of payments. For example, during boom period, imports may
increase considerably due to increase in demand for imported goods. During recession,
imports may be reduced due to fall in demand on account of reduced income.
Also, the importing countries may face cyclical changes. For instance, there may be
recession (negative growth) in the importing countries, which in turn would reduce
demand for imports. Therefore, the demand for exports will decline and the exporting
country may face a trade deficit, which in turn may affect BoP positions.

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Hence, cyclical disequilibrium in the balance of payments arises due to business

cycles. It is caused (a) by cyclical patterns of income, or (b) by different income
elasticity's, or (c) by different price elasticity's. These factors bring changes in the
terms of trade as well as growth of trade which, in turn, lead to a deficit or surplus in
the balance of payments.
When prices rise in prosperity, a country with more elastic demand for imports will
experience a decline in the value of imports, thus leading to a surplus in the balance of
payments. Conversely, as prices decline in depression, more elastic demand will
increase imports and cause a deficit in the balance of payments.
2. Secular Disequilibrium:
Secular or long-term disequilibrium in balance of payments occurs because of long-
seated and deep-rooted changes in the economy as it moves from one stage of growth
to another. It is secular disequilibrium emerging on account of the chronologically
accumulated short-term disequilibria – deficits or surpluses. It endangers the exchange
stability of the country concerned. Especially, a long-term deficit in the balance of
payments of a country tends to deplete its foreign exchange reserves and the country
may also not be able to raise any more loans from foreigners during such a period of
persistent deficits. The movements of the stages are:
(a) In the initial stages of economic development, domestic investment exceeds savings
and imports exceed exports. Disequilibrium occurs due to lack of funds to finance the
import surplus,
(b) Then a stage comes when domestic savings tend to exceed domestic investment and
exports exceed imports. Disequilibrium arises because the surplus savings exceed
investment opportunities abroad,
(c) At a still later stage, domestic savings tend to equal domestic investment and long-
term capital movements on balance become zero.
3. Structural Disequilibrium:
Structural disequilibrium in the balance of payments occurs when structural changes in
some sectors of the economy alter the demand and supply forces influencing exports
and imports. In other words, it takes place due to structural changes in the economy
affecting demand and supply relations in commodity and factor market.
Some of the important causes of structural disequilibrium are as follows:-

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a) If the foreign demand for a country's products decline due to the discovery of
cheaper substitutes abroad, then the country's export will decline causing a deficit.
b) If the supply position of a country is affected due factors like crop failure, shortage
of raw-materials, strikes, political instability, etc, then there would be the deficit in the
balance of payments.
c) A shift in demand due to the changes in tastes, fashions, income, etc, would increase
or decrease the demand for imported goods causing disequilibrium in the balance of
payments.
d) Changes in the rate of international capital movements may also cause structural
disequilibrium.
e) A war also results in structural changes which may affect not only the goods but also
factors of production causing disequilibrium in balance of payments.
f) Structural disequilibrium is also caused by changes in technology, tastes and attitude
towards foreign investment.
g) Any political disturbances, strikes, lockouts, etc, which affect the supply of exports,
also causes structural disequilibrium.
4. Fundamental Disequilibrium:
The term fundamental disequilibrium has been originally used by the I.M.F., to
indicate a persistent and long-term disequilibrium in a country's balance of payments.
Fundamental disequilibrium is generally caused by dynamic factors and particularly
leads to chronic deficit in the balance.
The main causes of fundamental disequilibrium are: (a) excessive or inadequate

internal demand for foreign goods; (b) excessive or inadequate competitive strength in
the world market; (c) excessive capital movements.
5. Technological Disequilibrium:
Technological disequilibrium in balance of payments is caused by various
technological changes involve inventions or innovations of new goods or new
technique of production. These technological changes affect the demand for factors and
goods.
A technological change will give comparative advantage to the innovating country

leading to the increase in exports or a decline in imports. This will create
disequilibrium in the balance of payments.

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Causes of Disequilibrium in Balance of Payment
1. Population Growth
Most countries experience an increase in the population and in some like India and
China the population is not only large but increases at a faster rate. To meet their
needs, imports become essential and the quantity of imports may increase as
population increases.
2. Development Programmes
Developing countries which have embarked upon planned development programmes
require importing capital goods, some raw materials which are not available at home
and highly skilled and specialized manpower. Since development is a continuous
process, imports of these items continue for the long time landing these countries in a
balance of payment deficit.
3. Short Supply
Disequilibrium of balance of payment arises due to a fall in supply. For example, due
to industrial strike the sugar production of India fall which affect the supply and as a
result there is a corresponding shortfall in exports and consequently increases the
amount of imports which is the result of disequilibrium.
4. Natural Factors
Natural calamities such as the failure of rains or the coming floods may easily cause
disequilibrium in the balance of payments by adversely affecting agriculture and
industrial production in the country. The exports may decline while the imports may go
up causing a discrepancy in the country's balance of payments.
5. Cyclical Fluctuations
Business fluctuations introduced by the operations of the trade cycles may also cause
disequilibrium in the country's balance of payments. For example, if there occurs a
business recession in foreign countries, it may easily cause a fall in the exports and
exchange earning of the country concerned, resulting in a disequilibrium in the balance
of payments.
6. Inflation
The greater bulk of balance of payments difficulties are the result of domestic inflation
and the same can be corrected by disinflation i.e., eliminating the inflationary gap and
reducing demand to the level of full employment. It is possible by increasing exports
and reducing imports. Similarly halting of inflation and correction of exchange rate
may also help in this regard.

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7. Poor Marketing Strategies

The superior marketing of the developed countries have increased their surplus. The
poor marketing facilities of the developing countries have pushed them into huge
deficits.
8. Flight of Capital
Due to speculative reasons, countries may lose foreign exchange or gold stocks. People
in developing countries may also shift their capital to developed countries to safeguard
against political uncertainties. These capital movements adversely affect the balance of
payments position.
9. Globalization
Due to globalization there has been more liberal and open atmosphere for international
movement of goods, services and capital. Competition has been increased due to the
globalization of international economic relations. The emerging new global economic
order has brought in certain problems for some countries which have resulted in the
balance of payments disequilibrium.
10. Technological Changes
No doubt, these are other significant reasons for disequilibrium in balance of payments
positions. It is quite known that every change in technology brings some comparative
advantages which the other country tries to adjust, but the adjustment process itself
brings a deficit in balance of payments.
Thus, the innovation, whatever form it is, invites disequilibrium. So, a new equilibrium
requires either to reduce exports or to increase imports.
Measures to correct disequilibrium in balance of payment
A) Monetary Measures for Correcting the BoP
1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct deficit
disequilibrium. A country faces deficit when its imports exceeds exports.
Deflation is brought through monetary measures like bank rate policy, open market
operations, etc or through fiscal measures like higher taxation, reduction in public
expenditure, etc. Deflation would make our items cheaper in a foreign market which
will result in a rise in our exports. At the same time the demands for imports fall due to
higher taxation and reduced income. This would build a favourable atmosphere in the

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balance of payment position. However Deflation can be successful when the exchange
rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline in the rate of exchange of domestic currency in

terms of foreign currency. This device implies that a country has adopted a flexible
exchange rate policy.
Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If
India experiences an adverse balance of payments with regard to U.S.A, the Indian
demand for US dollar will rise. The price of dollar in terms of rupee will rise. Hence,
dollar will appreciate in external value and rupee will depreciate in external value. The
new rate of exchange may be say $1 = Rs. 50. This means 25% exchange depreciation
of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will
become cheaper and imports costlier. Hence, a favourable balance of payments would
emerge to pay off the deficit.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities to bring down

the value of home currency against foreign currency. While depreciation is a
spontaneous fall due to interactions of market forces, devaluation is official act
enforced by the monetary authority. Generally the international monetary fund
advocates the policy of devaluation as a corrective measure of disequilibrium for the
countries facing adverse balance of payment position. When India's balance of
payment worsened in 1991, IMF suggested devaluation. Accordingly, the value of
Indian currency has been reduced by 18 to 20% in terms of various currencies. The
1991 devaluation brought the desired effect. The very next year the import declined
while exports picked up.
When devaluation is effected, the value of home currency goes down against foreign
currency, Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let
us suppose, devaluation takes place which reduces the value of home currency and now
the exchange rate becomes $1 = Rs. 20. After such a change our goods becomes cheap
in foreign market. This is because, after devaluation, dollar is exchanged for more

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Indian currencies which push up the demand for exports. At the same time, imports
become costlier as Indians have to pay more currencies to obtain one dollar. Thus
demand for imports is reduced.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control over
the exchange dealings. Under such a measure, the central bank directs all exporters to
surrender their foreign exchange to the central authority. Thus it leads to concentration
of exchange reserves in the hands of central authority. At the same time, the supply of
foreign exchange is restricted only for essential goods. It can only help controlling
situation from turning worse. In short it is only a temporary measure and not
permanent remedy.
B) Non-Monetary Measures for Correcting the BoP
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of
imports would increase to the extent of tariff. The increased prices will reduced the
demand for imported goods and at the same time induce domestic producers to produce
more of import substitutes. Non-essential imports can be drastically reduced by
imposing a very high rate of tariff.
2. Quotas
Under the quota system, the government may fix and permit the maximum quantity or
value of a commodity to be imported during a given period. By restricting imports
through the quota system, the deficit is reduced and the balance of payments position is
improved.
3. Export Promotion
The government can adopt export promotion measures to correct disequilibrium in the
balance of payments. This includes substitutes, tax concessions to exporters, marketing
facilities, credit and incentives to exporters, etc.

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The government may also help to promote export through exhibition, trade fairs;
conducting marketing research & by providing the required administrative and
diplomatic help to tap the potential markets.
4. Import Substitution
A country may resort to import substitution to reduce the volume of imports and make
it self-reliant. Fiscal and monetary measures may be adopted to encourage industries
producing import substitutes. Industries which produce import substitutes require
special attention in the form of various concessions, which include tax concession,
technical assistance, subsidies, providing scarce inputs, etc.
Non-monetary methods are more effective than monetary methods and are normally
applicable in correcting an adverse balance of payments.
Accounting Principles for BoP – Thumb rules

Simple thumb rules involving current account and capital account transactions under
BoP of a resident country:
Particulars / Transactions Debit (outflow) Credit (inflow)
Goods Buy Sell
Services Buy Sell
Unilateral transfers Give Receive
Investment income Pay Receive
Portfolio (short-term), when increase Buying a short-term asset or Selling a domestic

in foreign assets or decrease in receiving a payment from a short-term asset or
foreign liabilities (Dr) and for vice- foreigner making a payment to
versa (Cr) a foreigner
Portfolio (long-term) Buying a long-term foreign Selling a domestic
asset long-term asset to a
foreigner
Foreign Direct Investment Buying a foreign asset for Selling a long-term

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the purpose of control foreign asset

Accounting for Balance of Payments
Example-1: Country A exports goods worth 500 to Country B. The goods have been
invoiced in and will be paid for in Country B’s currency.
Payment will be effected by crediting the bank a/c which country A exporter holds
with a bank in country B. The balance in such an a/c is a foreign asset in country A and
a foreign liability for country B.
In country A’s BOP, this will be recorded as:
Current Account
Credit Debit
Merchandise Exports 500
Capital Account
Credit Debit
Increase in claims on a foreign bank 500
(Increase in foreign asset abroad)
Example-2: Country A agrees to supply leather goods worth 300 to Country B in return
for crude oil worth 300 both valued in Country B’s currency. In country A’s BOP:
Current Account
Credit Debit
Merchandise Imports 300
Example-3: A bank in Country A purchases securities issued by the Govt. of Country
B, valued at 200 in B’s currency and pays for them by drawing on an account it has
with its correspondent bank in country B. In country A’s BOP:
Capital Account
Credit Debit
Increase in foreign bond holdings 200
Decrease in foreign bank deposits 200
(Increase in foreign assets – debit and decrease in foreign assets – credit)
Example-4: US government gives a US bank balance of $10000 to the government of a
developing nation as part of the US aid programme. In developing country BOP:
Current Account
Credit Debit
Unilateral transfers $10000
Short-term capital inflow $10000

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(It results in receiving a payment from abroad and debited)

Example-5: An Indian resident visits UK and spends Rs.100000 on hotel and meals in
UK through Indian Traveler's cheques. In Indian BOP:
Current Account
Debit Credit
Travel Services (Expenditure) 100000
(A service received by India is like import and debited)
Short-term capital inflow 100000
(It results in increase in foreign liability and a liability for making a payment as
the traveler’s cheques are deposited for encashment)
Problem for 8 marks:

Record the following transactions and prepare the balance of payments statement:
a) A US firm exports $1000 worth of goods to be paid in six months.
b) A US resident visits London and spends $400 on hotel and meals.
c) US government gives a US bank balance of $200 to the government of a developing
nation as part of the US aid programme.
d) A US resident purchases foreign stock for $800 and pays for it by increasing the
foreign bank balances in the US.
e) A foreign investor purchases $600 of United States treasury bills and pays by
drawing down his bank balance in the United States by an equal amount.
Accounting for Balance of Payments (in $)

Particulars Debit (-) Credit (+)
a) Short-term capital outflow 1000
(Increase in claim from abroad / foreign bank)
b) Travel Services 400
(It results in increase in foreign liability)
c) Unilateral Transfer 200
(It results in crediting the bank a/c of recipient)
d) Long-term capital outflow 800
(It results in buying of long-term asset / increase in
financial asset & increase in foreign liability)

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e) Short-term capital outflow 600

(reduction in foreign bank balance in the US, short-
term capital inflow to the US bank)
(Selling the US treasury bills to a foreigner)
US Balance of Payments (in $)
Services 400
Unilateral Transfers 200
Long-term capital 800
Short-term capital, net 400
Totals 1400 1400
Problem for 12 marks:

From the following, record the transactions from the point of view of Country A and
prepare the current account of balance of payments statement:
a) Country A exports goods to B for $51000. B signs a bill of exchange for the goods
they imported from A.
b) B is a producer of gold and produces $1 million worth of gold and 10% is sold to
A’s Central Bank. For the gold exported to A, B accepts a deposit with the central bank
of Country A. Also, Country A imports goods from C for $800 and pays to the
exporting Country C with a loan in C’s currency which they get from A’s bank.
c) Citizen of A, migrated from Denmark a long time ago, inherits the property of his
uncle. The property consists of a farm house worth $2,000 and a deposit of $10,000 in
Denmark bank.
d) Another resident of Country A, who has migrated from Britain, decides to gift his
father $1200 and his father uses this money to buy bonds from another citizen of
Country A.
e) Country A resident goes on a vacation to India and spends all his $5000 for the
services received by him in India while on vacation.
f) Mr. Z (resident of A) makes a profit of $10,000 in the first year of operations in
Country B which Mr. Z uses to enlarge his business in Country B.
Country A Balance of Payments Statement
Particulars In $ In $
Current Account

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Merchandise
Exports 51000
Imports -100800
Balance -49800
Services
Receipts 10000
Payments -5000
Balance 5000
Unilateral Transfers
Gifts received 12000
Gifts to foreigners -1200
Balance 10800
Current Account Balance -34000
Accounting for Balance of Payments (in $)

a) Short-term capital 51000
(Increase in claim from abroad / foreign bank)
b) Import (gold) 100000
Merchandise Imports (Import of goods) 800
Short-term capital 100800
(It results in increase in foreign liability) (Claim by
foreigner)
c) Short-term capital (money in Denmark bank – claim on 10000
foreigner)
Long-term capital (fixed asset) 2000
Unilateral Transfer (Gift received) 12000
(It results in increase in fixed asset and increase in
foreign asset)
d) Unilateral Transfer (Gift given) 1200
Long-term capital (buying bonds) 1200
(It results in selling of long-term asset & liability to
foreigners)
e) Services received 5000
Short-term capital (liability for A’s currency) 5000
(It results in increase in liability to pay)
f) Direct Foreign Investment (to expand business) 10000
Profits (receipts) 10000

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(Profits are used for making payments to foreigners)
INTERNATIONAL MONETARY SYSTEM (UNIT-3)

Meaning: International monetary system refers to the system and rules that govern the
use and exchange of money around the world and between countries. Each country has
its own currency as money and the international monetary system governs the rules for
valuing and exchanging these currencies.
An international monetary system is a set of internationally agreed rules, conventions

and supporting institutions that facilitate international trade, cross border
investment and generally the reallocation of capital between nations. It should provide
means of payment acceptable to buyers and sellers of different nationalities, including
deferred payment. To operate successfully, it needs to inspire confidence, to provide
sufficient liquidity for fluctuating levels of trade, and to provide means by which
global imbalances can be corrected.
The international monetary system, as is seen today, has evolved over the course of
centuries and defines the overall financial environment in which multinational
corporations operate. Evolution of the international monetary system can be analyzed
in four stages as follows:
1) The Gold Standard, 1876 – 1913

2) The Inter-war years, 1914 – 1944
3) The Bretton Woods System, 1945 – 1973
4) Flexible Exchange Rate Regime since 1973
The Gold Standard, 1876 – 1913

This is the oldest system which was in operation till the beginning of the First World
War and a few years after that. In the early days, gold was used as storage of wealth
and a medium of exchange. This was under the version of Gold Specie Standard (or
price-specie-flow mechanism, specie meaning gold) where the actual currency in
circulation consisted of gold coins with a fixed gold content. Then in a version of Gold
Bullion Standard, the basis of money remains a fixed weight of gold but the currency
in circulation consists of paper notes with the monetary authorities, i.e. the central bank
of the country, standing ready to convert on demand, unlimited amounts of paper
currency in to gold and vice versa, at a fixed conversion ratio. For example, the US

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declared the dollar to be convertible to gold at a rate of $20.67 / ounce of gold. (One
ounce of standard gold = 28.35 grams). The British pound declared at L 4.2474 / ounce
of gold. Thus, the dollar-pound exchange rate would be determined as follows:
$ 20.67 / ounce of gold divided by L 4.2474 / ounce of gold = $ 4.866 / L
The gold standard, as an international monetary system, gained acceptance in Western

Europe in the 1870s and existed as a historical reality during the period 1875-1914.
The fundamental principle of the classical gold standard was that each country should
set a par value for its currency in terms of gold and then try to maintain this value.
Therefore, each country had to establish the rate at which its currency could be
converted to the weight of gold.
Thus, the three important features of the gold standard were:

i) The government of each country defines its national monetary unit in terms of gold
ii) Free import and export of gold and
iii) Two-way convertibility between gold and national currencies at a stable ratio.
Decline of the Gold Standard
There are certain reasons why the gold standard could not function well over the long
run. Firstly, the price-specie-flow mechanism was unrealistic. This mechanism had
rules of the game which had to be adhered to and was difficult, like currencies must be
valued in terms of gold, free flow of gold, issuance of notes in relation to a country’s
gold holdings. Such rules required the nations willingness and above the domestic
policy goals. Secondly, gold is a scarce commodity and gold volume could not grow
fast enough to allow adequate amounts of money to be printed. Thirdly, gold was
being taken out of reserve for art and industrial consumption, when the desire of many
people was to own gold. The hoarding of gold was banned. Fourthly, the system was
with unrealistic expectation that countries would subordinate their national economies
to the dictates of gold as well as to external and monetary conditions. This led to
situations like countries with high inflation or trade deficit was required to reduce its
money supply and consumption, resulting in recession and unemployment. This strict
discipline many nations could not force upon themselves.
Due to the rigidity of the system, it was a matter of time before major countries
decided to abandon the gold standard, starting with the United Kingdom in 1931 in the

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midst of a worldwide recession and UK witnessed 12% unemployment with a

monetary chaos in many countries.
The Inter-war years, 1914 – 1944
The gold standard as an international monetary system worked well until World War I
interrupted trade flows and disturbed the stability of exchange rates for currencies of
major countries. There was widespread fluctuation in currencies in terms of gold
during World War I and in early 1920’s. As countries began to recover from the war
and stabilize their economies, they made several attempts to return to the gold
standard. The United States returned to gold in 1919 and the United Kingdom in 1925.
Countries such as Switzerland, France and Scandinavian countries restored the gold
standard by 1928.
The key currency involved in the attempt to restore the international gold standard was
the pound sterling which returned to gold in 1925 at the old mint parity exchange rate
of $4.866 / L. This was a great mistake since the UK had experienced considerably
more inflation than the US and because UK had liquidated most its foreign investment
in financing the war. The result was increased unemployment and economic stagnation
in Britain. Other problems included the failure of the US to act responsibly, the
undervaluation of the French Franc and a general decrease in the willingness and
ability of nations to rely on the gold standard adjustment mechanism.
Thus the inter-war period was characterized by half-hearted attempts and failures to
restore the gold standard, economic and political instabilities, widely fluctuating
exchange rates, bank failures and financial crisis. The Great Depression in 1929 and
the stock market crash also resulted in the collapse of many banks.
The Bretton Woods System, 1945 – 1973
The depression of the 1930’s, followed by another war, and had vastly diminished
commercial trade, the international exchange of currencies and cross-border lending
and borrowing. What were left were only memories of what the system had once been.
Revival of the system was necessary and the reconstruction of the post-war financial
system began with the Bretton Woods Agreement that emerged from the International
Monetary and Financial Conference of the united and associated nations in July 1944
at Bretton Woods, New Hampshire in US. There was a general agreement that
restoring the gold standard was out of question and that the exchange rates should

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basically be stable. The governments needed access to credits in convertible currencies

if they were to stabilize the exchange rates.
The negotiations at Bretton Woods made certain recommendations in 1944:
 Each nation should be at liberty to use macroeconomic policies for full

employment and ruled out a return to the gold standard.
 Free-floating exchange rates could not work. Their ineffectiveness had been
demonstrated during the 1920s and 1930s. But the extremes of both permanently
fixed and free-floating rates should be avoided.
 A monetary system was needed that would recognize that exchange rates were
both a national and an international concern.
The agreement established a dollar based International Monetary System and created
two new institutions: a) The International Monetary Fund (IMF) and b) The
International Bank for Reconstruction and Development (World Bank). The basic role
of the IMF would be to help countries with balance of payments and exchange rate
problems while the World Bank would help countries with post-war reconstruction and
general economic development.
Thus, the main points of the post-war system evolving from the Bretton Woods
Conference were as follows:
1. A new institution, the IMF would be established in Washington DC

2. The US dollar (and, de facto, the British pound) would be designated as reserve
currencies and other nations would maintain their foreign exchange reserves
principally in the form of dollars or pounds
3. Each Fund (the IMF) member would establish a par value for its currency and
maintain the exchange rate for its currency within one percent of par value
4. The US separately agreed to buy gold from or sell gold to foreign official
monetary authorities at $35 per ounce settlement of international transactions
5. A Fund member could change its par value only with the Fund approval and
only if the country’s balance of payments was in disequilibrium
6. After a post-war transition period, currencies were to become convertible. It
means that currencies could be freely bought and sold for other foreign
currencies. Restrictions were to be removed and to keep market exchange rates
within one percent of par value.

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7. The Fund would get gold and currencies to lend through “subscription”. That is,
countries would have to make a payment (subscription) of gold and currency to
the IMF in order to become a member and quotas were assigned.
The Bretton Woods System worked without major changes from 1947 to 1971.
International trade expanded in real terms at a faster rate than world output and
currencies of many nations, particularly those of developed countries, became
convertible. But, this Bretton Woods System also resulted in its breakdown, as it
suffered from a number of inherent structural problems. There was much imbalance in
the roles and responsibilities of the surplus and deficit nations. Countries with
persistent deficits in their BoP had to undergo tight and stringent economic policies if
they wanted to take help from the IMF and stop the drain on their reserves.
There was the rigid approach adopted by the IMF to the BoP disequilibria situation.
The controversy centers on the ‘conditionality issue’ which refers to a set of rules and
policies that a member country is required to pursue as a prerequisite to using the IMF
resources. In this system, the US dollar became international money. Other countries
accumulated and held dollar balances with which they could settle their international
payments. The US could in principle buy goods and services from other countries
simply by paying with its own currency. This system could work as long as other
countries had confidence in the stability of the US dollar and in the ability of the US
treasury to convert dollars into gold on demand at specified conversion rate. But the
system came under pressure and in 1971, the US government abandoned its
commitment to convert dollars into gold at the fixed price of $35 per ounce and the
major currencies went on float. Finally, this system was given up in 1973 and the
world moved to a system of floating rates.
Flexible Exchange Rate Regime since 1973
An exchange-rate regime is the way an authority manages its currency in relation to

other currencies and the foreign exchange market. It is closely related to monetary
policy and the two are generally dependent on many of the same factors, such as
economic scale and openness, inflation rate, elasticity of labor market, financial market
development, capital mobility and etc.
In other words, an exchange rate regime is the system that a country’s monetary
authority (generally the central bank) adopts to establish the exchange rate of its own
currency against other currencies. Each country is free to adopt the exchange-rate

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regime that it considers optimal, and will do so using mostly monetary and sometimes
even fiscal policies.
There are two major regime types: fixed (or pegged) exchange rate regimes where the
currency is tied to another currency, mostly reserve currencies such as the US dollar or
the euro or a basket of currencies; floating (or flexible) exchange rate regimes, where
the economy dictates movements in the exchange rate.
Fixed exchange rate regimes, sometimes called a pegged exchange rate regime, are
those in which a country's exchange rate fluctuates in a narrow range (or not at all)
against some base currency or to other measure of value over a sustained period,
usually a year or longer. A country's exchange rate can remain rigidly fixed for long
periods only if the government intervenes in the foreign exchange market in one or
both countries.
Floating (or flexible) exchange rate regimes are those in which a country's exchange
rate fluctuates in a wider range and the government makes no attempt to fix it against
any base currency. Appreciations and depreciations may occur from year to year, each
month, by the day, or every minute. In other words, floating exchange rates mean that
currencies change in relative value all the time. For example, one U.S. dollar might buy
one British Pound today, but it might only buy 0.95 British Pounds tomorrow. The
value "floats”.
Why It Matters?
Activity in the foreign exchange (Forex) markets determines the exchange rates for
floating currencies because those markets reflect the supply and demand for a
particular currency. This is not the case for currencies with fixed exchange rates (often
called "pegged" currencies), where a country's central bank intervenes and stabilizes or
regulates the value of the currency by buying and selling its own currency reserves in
return for the currency to which it is pegged. Floating exchange rates create exchange
rate risk (also called currency risk). This risk is important to foreign investors, because
it means that when exchange rates change, the amount of money the investor sees at
the end of the day changes too.
Under the fixed systems, excessive demand for gold developed and the US was forced
to suspend the sale of gold in 1968, except to official parties. But this did not help and

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by late 1960s, the dollar came under increasing pressure because of the prolonged and
steep deterioration of the BoP. A crisis of confidence developed and foreigner’s
reluctance to hold dollars resulted in a change in the dollars historic value. The US
dollar was severely affected (1978 crisis) with inflation in the United States that
prompted a panic selling of the dollar. The dollar decline reduced the American
Consumers purchasing power, the soaring prices hurt the anti-inflation programme,
stock values lost several millions of dollars and the resulting declining value of dollar
reserves encouraged the increase of oil prices by OPEC members. All this resulted in a
large-scale retrenchment of business investment plans. The dollar was allowed to float
and a flexible or floating system came in under which a currency value would be based
on demand and supply of money.
The flexible exchange rate systems came with the following significance/advantages:
a) Flexible exchange rates as automatic stabilizers: The necessity of maintaining

internal and external balance under a metallic standard is based on the fact that a
metallic standard leads to a fixed exchange rate regime. If the relative price of
currencies is fixed and a country’s output, employment, and current account
performance and other relevant economic variables change, the exchange rate
cannot change. This fact causes friction in the entire economic system. However,
if exchange rates are allowed to change, they change in the appropriate direction,
given the nature of changes in the variables affecting the exchange rates. The
monetary policy and growth performance of a country affect exchange rates.
b) Monetary policy autonomy: Under the flexible exchange rate regime, countries
can implement autonomous monetary policies to address problems with inflation
and output. Because monetary policies affect inflation rates, countries can decide
on their long-run inflation rate and don’t have to import their trade partners’
inflation rate, as is the case under a fixed exchange rate.
c) Automatic Adjustment in BOP: The chief merit of the freely fluctuating
exchange rate is that the BOP disequilibrium gets corrected automatically with
the change in exchange rate.
d) No Collusion between Internal-External Objectives: Surplus and deficit in the
BOP accounts get corrected if foreign exchange rate falls and rises, respectively.
e) Absorption of Sudden Shocks: In a flexible exchange rate, the domestic
economy remains insulated from external shocks and pressures. Under this

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system, the threat of ‘importing inflation’ from outside the country is at its
minimum.
f) Minimum Buffer of Foreign Exchange Reserves: Since exchange rate is not
pegged under the floating arrangement of exchange rate, the central bank of a
country need not hold adequate foreign exchange reserves as a buffer against
unforeseen developments in international trade.
Alternative Exchange Rate Systems
The turmoil in exchange markets did not ease when major currencies were allowed to
float since the beginning of March 1973. Since 1973, most industrial countries and
many developing countries allowed their currencies to float with government
intervention, whenever necessary, in the foreign exchange market. The alternative
exchange rate systems which followed are:
1) Exchange Arrangements with no separate legal tender:
Under this regime a country either adopts the currency of another country as its legal
tender or a group of countries share a common currency. Examples of the former
arrangement are countries like Ecuador and Panama which have adopted the US dollar
as their legal tender. The most prominent example of the latter category is of course the
European Union, the sixteen member countries of which all have euro as their
currency. In addition, a few countries which are not part of the European Union have
also adopted euro as their currency. Obviously a country adopting such a regime
cannot have an independent monetary policy.
2) Currency Board Arrangements:
This is a regime under which there is a legislative commitment to exchange the

domestic currency against a specified foreign currency at a fixed exchange rate coupled
with restrictions on the monetary authority to ensure that this commitment will be
honored. This implies constraints on the ability of the monetary authority to manipulate
domestic money supply. In 2006, IMF classified seven countries – Bosnia, Brunei,
Bulgaria, Djibouti, Estonia, Hong Kong and Lithuania – as having a currency board
system. Estonia has recently joined the EU and adopted euro as its currency.

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3) Conventional Fixed Peg Arrangements:
This is identical to the Bretton Woods System where a country pegs its currency to
another or to a basket of currencies with a band of variation not exceeding + (-) 1%
around the central parity. The peg is adjustable at the discretion of the domestic
authorities. Forty nine IMF members have this regime as of 2006.
4) Crawling Peg:
This is another variant of a limited flexibility regime. The currency is pegged to

another currency or a basket, but the peg is periodically adjusted. The adjustment may
be pre-announced and according to a well-specified criterion or discretionary. Five
countries were under such a regime in 2006. The idea was to adjust the rate slowly (or
crawl) by small amounts at any point in time on a continuous basis to correct for any
overvaluation and undervaluation.
5) Crawling Bands:
The market value of a national currency is permitted to fluctuate within a range

specified by a band of fluctuation. This band is determined by international agreements
or by unilateral decision by a central bank. In other words, a currency is said to be
pegged within a band when the central bank specifies a central exchange rate with
reference to a single currency, a co-operative arrangement or a currency composite
(basket of currency). Depending on the band width, the central bank has discretion in
carrying out its monetary policy. The band itself is a crawling one, which implies that
the central rate is adjusted periodically.
6) Managed Floating with no Pre-announced path for the Exchange Rate:
The central bank influences or attempts to influence the exchange rate by means of
active intervention in the foreign exchange market – buying or selling foreign currency
against the home currency – without any commitment to maintain the rate at any
particular level or keep it on any pre-announced trajectory. Fifty three countries
including India were classified as belonging to this group in 2006.
7) Independently Floating:
The exchange rate is market determined with central bank intervening only to moderate
the speed of change and to prevent excessive fluctuations, but not attempting to

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maintain or drive it towards any particular level. In 2008, about one-fifth of the IMF
members characterized themselves as independent floaters. It is evident from this that
unlike in the pre-1973 years, one cannot characterize the international monetary regime
with a single label.
International Monetary Fund
The origin of the IMF goes back to the days of international chaos of the 1930s. During
the Second World War, plans for the construction of an international institution for the
establishment of monetary order were taken up.
At the Bretton Woods Conference held in July 1944, delegates from 44 non-communist
countries negotiated an agreement on the structure and operation of the international
monetary system. A landmark in the history of world economic cooperation is the
creation of the International Monetary Fund, briefly called IMF. The IMF was
organized in 1946 and commenced operations in March, 1947.
The Articles of Agreement of the IMF provided the basis of the international monetary
system. The IMF commenced financial operations on 1 March 1947, though it came
into official existence on 27 December 1945, when 29 countries signed its Articles of
Agreement (its charter). Its policies and activities are guided by this charter (A of A).
Now, the IMF has near-global membership of 188 member countries. Virtually, the
entire world belongs to the IMF. India is one of the founder- members of the Fund.
The fundamental object of the IMF was the avoidance of competitive devaluation and
exchange control that had characterized the era of 1930s. It was set up to administer a
“code of fair practice”, in the field of foreign exchange and to make short-term loans to
member nations experiencing temporary deficits in their balance of payments, to
enable them to meet these payments without resorting to devaluation or exchange
control, while at the same time following’ international policies to maintain domestic
income and employment at high levels.
The IMF is an independent international organization. It is a cooperative of 189

member countries, whose objective is to promote world economic stability and growth.
The member countries are the shareholders of the cooperative, providing the capital of
the IMF through quota subscriptions. In return, the IMF provides its members with
macroeconomic policy advice, financing in times of balance of payments need, and
technical assistance and training to improve national economic management. The IMF

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is one of several autonomous organizations designated by the United Nations (UN) as

“Specialized Agencies,” with which the UN has established working relationships. The
IMF is a permanent observer at the UN.
Objectives of International Monetary Fund:

The main objectives of IMF, as noted in the Articles of Agreement, are as follows:
(i) International Monetary Co-Operation:
The most important objective of the Fund is to establish international monetary co-
operation amongst the various member countries through a permanent institution that
provides the machinery for consultation and collaborations in various international
monetary problems and issues.
(ii) Ensure Exchange Stability:
Another important objective of the Fund is to ensure stability in the foreign exchange
rates by maintaining orderly exchange arrangement among members and also to rule
out unnecessary competitive exchange depreciations.
(iii) Balanced Growth of Trade:
IMF has also another important objective to promote international trade so as to

achieve its required expansion and balanced growth. This would ensure development
of production resources and thereby promote and maintain high levels of income and
employment among all its member countries.
(iv) Eliminate Exchange Control:
Another important objective of the Fund is to eliminate or relax exchange controls

imposed by almost each and every country before Second World War as a device to
deliberately fix the exchange rate at a particular level. Such elimination of exchange
controls was made so as to give encouragement to the flow of international trade.
(v) Multilateral Trade and Payments:
To establish a multilateral trade and payment system in respect to current transactions

between members in place of the old system of bilateral trade agreements was another
important objective of IMF.

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(vi) Correction of BoP maladjustments:
IMF also helps the member countries in eliminating or reducing the disequilibrium or
maladjustments in balance of payments. Accordingly, it gives confidence to members
by selling or lending Fund’s foreign currency resources to the member nations.
(vii) Promote Investment of Capital:
Finally, the IMF also promotes the flow of capital from richer to poorer or backward
countries so as to help the backward countries to develop their own economic
resources for attaining higher standard of living for its people, in general.
Functions of International Monetary Fund are as follows:

1. Exchange Stability:
The first important function of IMF is to maintain exchange stability and thereby to
discourage any fluctuations in the rate of exchange. The Fund ensures such stability by
making necessary arrangements like – enforcing declaration of par value of currency of
all members in terms of gold or US dollar, enforcing devaluation criteria, up to 10 per
cent or more by more information or by taking permission from IMF respectively,
forbidding members to go in for multiple exchange rates and also forbidding to buy or
sell gold at prices other than declared par value.
2. Eliminating BOP Disequilibrium:
The Fund is helping the member countries in eliminating or minimizing the short-
period equilibrium of balance of payments either by selling or lending foreign
currencies to the members. The Fund also helps its members towards removing the
long period disequilibrium in their balance of payments. In case of fundamental
changes in the economies of its members, the Fund can advise its members to change
the par values of its currencies.
3. Determination of Par Value:
IMF enforces the system of determination of par values of the currencies of the
member’s countries. As per the Original Articles of Agreement of the IMF every
member country must declare the par value of its currency in terms of gold or US
dollars. Under the revised Articles, the members are given autonomy to float or change

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exchange rates as per demand supply conditions in the exchange market and also at par
with internal price levels. At the same time, IMF is exercising surveillance to ensure
proper working in the international monetary system, by avoiding manipulation in the
exchange rates.
4. Credit Facilities:
IMF is maintaining various borrowing and credit facilities so as to help the member
countries in correcting disequilibrium in their balance of payments. These credit
facilities include – basic credit facility, extended fund facility for a period of 3 years,
compensatory financing facility, and Lucifer stock facility for helping the primary
producing countries, supplementary financing facility, structural adjustment facility
etc. The Fund also charges interest from the borrowing countries on their credit.
5. Stabilize Economies:
The IMF has an important function to advise the member countries on various
economic and monetary matters and thereby to help stabilize their economies.
6. Maintaining Balance between Demand and Supply of Currencies:
IMF is also entrusted with important function to maintain balance between demand and
supply of various currencies. Accordingly the fund can declare a currency as scarce
currency which is in great demand and can increase its supply by borrowing it from the
country concerned or by purchasing the same currency in exchange of gold.
7. Maintenance of Liquidity:
To maintain liquidity of its resources is another important function of IMF.

Accordingly, there is provision for the member countries to borrow from IMF by
surrendering their own currencies in exchange. IMF also helps accumulation of less
demand currencies with the Fund, the borrowing countries are directed to repurchase
their own currencies by repaying its loans in convertible currencies.
8. Technical Assistance:
The IMF is also performing a useful function to provide technical assistance to the
member countries. Such technical assistance is given in two ways, firstly by granting

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the members countries the services of its specialists and experts and secondly by
sending the outside experts.
9. Reducing Tariffs:
The Fund also aims at reducing tariffs and other restrictions imposed on international
trade by the member countries so as to cease restrictions of remittance of funds or to
avoid discriminating practices.
10. General Watch:
The IMF is also keeping a general watch on the monetary and fiscal policies followed
by the member countries to ensure no flouting of the provisions of the charter.
What are SDRs in the context of IMF? (Special Drawing Right)
The SDR was created as a supplementary international reserve asset in the context of
the Bretton Woods fixed exchange rate system. The collapse of Bretton Woods’s
system in 1973 and the shift of major currencies to floating exchange rate regimes
lessened the reliance on the SDR as a global reserve asset. The SDR serves as the unit
of account of the IMF and some other international organizations.
World Bank
The International Bank for Reconstruction and Development (IBRD), commonly

referred to as the World Bank, is an international financial institution whose purposes
include assisting the development of its member nation’s territories, promoting and
supplementing private foreign investment and promoting long-range balance growth in
international trade. Today, the World Bank functions as an international organization
that fights poverty by offering developmental assistance to middle-income and low-
income countries. By giving loans and offering advice and training in both the private
and public sectors, the World Bank aims to eliminate poverty by helping people help
themselves. In short, World Bank is an international financial institution that provides
loans to developing countries for development programs.
The World Bank was established in December 1945 at the United Nations Monetary
and Financial Conference in Bretton Woods, New Hampshire. It opened for business in
June 1946 and helped in the reconstruction of nations devastated by World War II.

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Since 1960s the World Bank has shifted its focus from the advanced industrialized
nations to developing third-world countries.
It comprises two institutions: the International Bank for Reconstruction and

Development (IBRD) and the International Development Association (IDA). The
World Bank is a component of the World Bank Group, and a member of the United
Nations Development Group.
Objectives of the World Bank
The main objectives of the World Bank are:
(1) Reconstruction and Development
The main objective of the bank is to reconstruct the war devastated economies like
Britain, France, and Holland etc. and to provide economic assistance to
underdeveloped countries like India, Pakistan, Sri Lanka, Burma etc.
(2) Encouragement to Capital Investment
An other important objective of the Bank is to encourage private investors to invest

capital in underdeveloped countries, by means of guarantee of participation in loans
and other investment made by private investors and when private capital is not
available on reasonable terms, to supplement private investment by providing on
suitable conditions finance for productive purposes out of its own capital, funds raised
by it and its other resources.
(3) Encouragement to International Trade
The third objective of the bank is to encourage international trade. It aims at promoting
long-range growth of international trade and maintenance of equilibrium in member’s
international balance of payments, so that standard of living of the people of member-
countries is raised.
(4) Establishment of Peace Time Economy
The fourth objective of the Bank is to help the member-countries changeover from
war-time economy to peace-time economy.

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(5) Environmental Protection
Global environmental protection is also an objective of Bank. To this end, World Bank
gives substantial financial assistance to those underdeveloped countries which are
engaged in the task of environmental protection.
6) Maintenance of equilibrium in balance of payment
To promote long term balanced growth of international trade and the maintenance of
equilibrium in balance of payments of member countries by encouraging long term
international investment so as to develop productive resources of members and thereby
raising its productivity, the standard of living and labour conditions.
Important Functions of World Bank
The functions performed by the World Bank follow from the objectives set out in its
articles when it was formed. They can be summed up as follows.
1. It grants loans for long and medium terms. Loans are divided in two types:
Reconstruction Loans and Development Loans. The first is given to countries damaged
by the last war, the second to all countries who require such loans for development
purposes.
2. The bank gives loans to governments and also to private borrowers (to industrial
concerns for particular projects). In the later case the bank demands a guarantee from
the government, the central bank and similar organizations of the region in which the
project is to be undertaken. The bank generally does not provide the entire cost of a
private project. The organizers are expected to bear at least a part of the cost.
3. Loans are granted after preliminary discussions with the parties and a critical
examination of the project. The bank’s help is given only after it is satisfied that the
project is a sound one.
4. The bank gives technical advice to the borrowers and for this purpose engages
experts.
5. The bank promotes foreign investments by guaranteeing loans made by other

organizations. The bank’s duty is to supplement and not to supersede the flow of
private risk capital.

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6. The World Bank’s capital is too small to provide for the development need of the
entire world. It has therefore set up a number of subsidiary organizations for further
finance.
7. The bank has certain miscellaneous functions. It can buy and sell security issued or
guaranteed by it or in which it has invested. But it must obtain the approval of the
member in whose territories the purchase or sale will take place.
8. It can guarantee securities in which it has invested. It can buy and sell other
securities if approved by three fourth of the directors’ voting power. It can borrow the
currency of any member with the approval of that member. The bank or its officials
must not interfere in political matters.
World Bank Group
The World Bank Group (WBG) is a family of five international organizations that
make leveraged loans to developing countries. It is the largest and most well-
known development bank in the world and is an observer at the United Nations
Development Group. The bank is based in Washington, D.C. The bank's stated mission
is to achieve the twin goals of ending extreme poverty and building shared prosperity.
The World Bank Group consists of:
1) The International Bank for Reconstruction and Development (IBRD):
It is an international financial institution that offers loans to middle-income

developing countries. The IBRD is the first of five member institutions that
compose the World Bank Group, and is headquartered in Washington, D.C.,
United States. It was established in 1944 with the mission of financing the
reconstruction of European nations devastated by World War II. The IBRD and
its concessional lending arm, the International Development Association, are
collectively known as the World Bank as they share the same leadership and staff.
Following the reconstruction of Europe, the Bank's mandate expanded to
advancing worldwide economic development and eradicating poverty.

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2) The International Finance Corporation (IFC):
It is an international financial institution that offers investment, advisory, and

asset-management services to encourage private-sector development in developing
countries. The IFC is a member of the World Bank Group and is headquartered
in Washington, D.C. It was established in 1956, as the private-sector arm of the
World Bank Group, to advance economic development by investing in for-profit
and commercial projects for poverty reduction and promoting development. The
IFC's stated aim is to create opportunities for people to escape poverty and
achieve better living standards by mobilizing financial resources for private
enterprise, promoting accessible and competitive markets, supporting businesses
and other private-sector entities, and creating jobs and delivering necessary
services to those who are poverty stricken or otherwise vulnerable.
3) The International Development Association (IDA):
It is an international financial institution which offers concessional loans and

grants to the world's poorest developing countries. The IDA is a member of
the World Bank Group and is headquartered in Washington, D.C., United States.
It was established in 1960 to complement the existing International Bank for
Reconstruction and Development by lending to developing countries which suffer
from the lowest gross national income, from troubled creditworthiness, or from
the lowest per capita income.
4) The International Centre for Settlement of Investment Disputes (ICSID):
It is an international arbitration institution established in 1966 for legal dispute

resolution and conciliation between international investors. The ICSID is part of
and funded by the World Bank Group, headquartered in Washington, D.C., in
the United States. It is an autonomous, multilateral specialized institution to
encourage international flow of investment and mitigate non-commercial risks by
a treaty drafted by the International Bank for Reconstruction and Development's
executive directors and signed by member countries. As of May 2016, 153
contracting member states agreed to enforce and uphold arbitral awards in
accordance with the ICSID Convention.

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5) The Multilateral Investment Guarantee Agency (MIGA):
It is an international financial institution which offers political risk insurance and

credit enhancement guarantees. These guarantees help investors protect foreign
direct investments against political and non-commercial risks in developing
countries. MIGA is a member of the World Bank Group and is headquartered
in Washington, D.C. MIGA was established in 1988 as an investment insurance
facility to encourage confident investment in developing countries.
The IBRD has 189 member governments, and the other institutions have between
153 and 184 members. Each member country appoints a governor, generally its
Minister of Finance. On a daily basis the World Bank Group is run by a Board of
25 Executive Directors to whom the governors have delegated certain powers.
Each Director represents either one country (for the largest countries), or a group
of countries. The agencies of the World Bank are each governed by their Articles
of Agreement that serve as the legal and institutional foundation for all of their
work.
Differences between IMF and World Bank
Basis for comparison IMF World Bank

a) Meaning International Monetary Fund World Bank is a global
an international organization organization established to
maintaining the global finance and advice the
monetary system, financial developing nations; in order
stability and encourage world to make them economically
trade developed
b) Focus on Economic stability Economic growth
c) Size 2300 staff members 7000 staff members
d) Organizational It is a single organization It has two major institutions,
Structure with four credit lines namely IBRD and the IDA
e) Operations Provides assistance Facilitates lending
f) Objectives To deal with all the issues To lessen poverty and
related to the financial sector promote the long term
and macro-economics development of the economy

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Capital account convertibility
Capital Account Convertibility means that rupee can now be freely convertible into any
foreign currencies for the acquisition of assets like shares, properties, and assets
abroad. Further, the banks can accept deposits in any currency. It means the freedom to
convert local financial assets into foreign financial assets and vice versa at market
determined rates of exchange. It refers to the removal of restraints on international
flows on a country’s capital account, enabling full currency convertibility and
the opening of the financial system.
Capital account convertibility is considered to be one of the major features of a

developed economy. It helps attract foreign investment. At the same time, capital
account convertibility makes it easier for domestic companies to tap foreign markets. It
is sometimes referred to as Capital Asset Liberation. Therefore, Capital account refers
to expenditures and investments in hard assets, physical premises, and factories as well
as investments in land and other capital-intensive items.
Current account convertibility
Current account convertibility allows free inflows and outflows for all purposes other
than for capital purposes such as investments and loans. In other words, it allows
residents to make and receive trade-related payments – receive dollars (or any other
foreign currency) for export of goods and services and pay dollars for import of goods
and services, make sundry remittances, access foreign currency for travel, studies
abroad, medical treatment and gifts, etc.
Current account refers to investments that are short-term in duration for example
expenditure incurred for tourism, foreign education, medical treatment etc. and hence,
they fall under the current account head.
India currently has full convertibility of the rupee in current accounts such as for
exports and imports. However, India’s capital account convertibility is not full. There
are ceilings on government and corporate debt, external commercial borrowings and
equity. In India both Capital account and Current account transaction are regulated by
The Foreign Exchange Management Act, 1999 which lays down the rules for current
account and capital account convertibility and also affixing the monetary limit for both.

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THE FOREIGN EXCHANGE MARKET (UNIT-4)

Definition: The Foreign Exchange Market is a market where the buyers and sellers are
involved in the sale and purchase of foreign currencies. In other words, a market where
the currencies of different countries are bought and sold is called a foreign exchange
market.
Meaning: It means that the foreign exchange market (also called Forex, FX, or
currency market) trades currencies. In International Finance, money flows often require
the use of currencies other than the national currencies of the parties to the transactions.
The foreign exchange market is the market which accommodates the currency
preferences of the parties involved and helps convert one currency into the other
currency. It is yet another market where one currency is traded for another. The foreign
exchange market is an over-the-counter market. This means that there is no single
physical or electronic market place or an organized exchange (like a stock exchange)
with a central clearing mechanism where traders meet and exchange currencies. The
currency market is considered to be the largest financial market in the world. Apart
from providing a floor for the buying, selling, exchanging and speculation of
currencies, the forex market also enables currency conversion for international trade
and investments.
Market Participants: The structure of the foreign exchange market constitutes central
banks, commercial banks, brokers, exporters and importers, immigrants, investors,
tourists. These are the main players of the foreign market; their position and place are
shown in the figure below:

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At the bottom of a pyramid are the actual buyers and sellers of the foreign currencies-
exporters, importers, tourist, investors, and immigrants. They are actual users of the
currencies and approach commercial banks to buy it.
The commercial banks are the second most important organ of the foreign exchange
market. The banks dealing in foreign exchange play a role of “market makers”, in the
sense that they quote on a daily basis the foreign exchange rates for buying and selling
of the foreign currencies. Also, they function as “clearing houses”, thereby helping in
wiping out the difference between the demand for and the supply of currencies. These
banks buy the currencies from the brokers and sell it to the buyers.
The third layer of a pyramid constitutes the foreign exchange brokers. These brokers
function as a link between the central bank and the commercial banks and also between
the actual buyers and commercial banks. They are the major source of market
information. These are the persons who do not themselves buy the foreign currency,
but rather strike a deal between the buyer and the seller on a commission basis.
The central bank of any country is the apex body in the organization of the exchange
market. They work as the lender of the last resort and the custodian of foreign
exchange of the country. The central bank has the power to regulate and control the
foreign exchange market so as to assure that it works in the orderly fashion. One of the
major functions of the central bank is to prevent the aggressive fluctuations in the
foreign exchange market, if necessary, by direct intervention. Intervention by central
bank is in the form of selling the currency when it is overvalued, and buying it when it
tends to be undervalued.
Information and Communication Systems:
Foreign exchange markets make extensive use of the latest developments in

telecommunications for transmitting as well settling foreign exchange transaction,
Banks use the exclusive network SWIFT to communicate messages and settle the
transactions at electronic clearing houses such as CHIPS at New York. It is a computer
based communications system that links banks and brokers in every financial centre
and the banks and brokers are in almost instant contact.
SWIFT stands for Society for Worldwide Interbank Financial Telecommunications, a

co operative society owned by about 250 banks in Europe and North America and
registered as a co operative society in Brussels, Belgium. It is a communications

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network for international financial market transactions linking effectively more than
25,000 financial institutions throughout the world that have been allotted bank
identified codes. The messages are transmitted from country to country via central
interconnected operating centers located in Brussels, Amsterdam and Culpeper,
Virginia. The member countries are connected to the centre through regional
processors in each country. The local banks in each country reach the regional
processors through the national net works.
The SWIFT System enables the member banks to transact among themselves quickly
(i) international payments (ii) Statements (iii) other messages connected with
international banking. Transmission of messages takes place within seconds, and
therefore this method is economical as well as time saving. Selected banks in India
have become members of SWIFT. The regional processing centre in India is situated at
Mumbai.
CHIPS stand for Clearing House Interbank Payment System. It is an electronic

payment system owned by 12 private commercial banks constituting the New York
Clearing House Association. A CHIP began its operations in 1971 and has grown to be
the world‘s largest payment system. Foreign exchange and Euro dollar transactions are
settled through CHIPS. It provides the mechanism for settlement every day of payment
and receipts of numerous dollar transactions among member banks at New York,
without the need for physical exchange of cheques/funds for each such transaction.
Characteristics of Foreign Exchange Market
The Foreign Currency Exchange Market is the worldwide largest market asset class
today. That decides the currency value of the global countries and allows doing
international currency exchange or trading. It has unique characteristics that make it
excel from the rest of the other financial markets.
1. Lower Trading Cost
In the forex market, the lower trading cost has made it possible for even small,
individual investors to make the decent profits from trading. With lower costs, the
possible losses are much lower. The forex trading has no commission fees unlike in
other investments. The forex trading cost is limited to the spread or the difference
between the buying and selling prices for a particular currency pair.

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2. 24 Hour Trading Opportunity 5 Days A Week
There are plenty of opportunities to execute trades and sufficient time to make
adjustments whenever and where ever such opportunities present themselves.
3. Highly Leveraged Market
Traders are allowed to trade on margins or technically on borrowed money with forex.
They get more value for your money as the returns can be magnified a hundredfold.
However, always remember that there always two sides of the coin when it comes to
leverage meaning it can also increase your losses.
4. Excellent Transparency
Forex trading is a transparent process because the forex trader has full access to market
data and information that are necessary to achieve successful transactions. The
excellent transparency that traders have more control over investments and decide what
to do based on the available information.
5. Access Advantage In Forex
Traders can access the foreign currency exchange market and their trading
account from anywhere using internet connection without difficulty and trade from
anywhere. With other financial markets, the trader need’s to be physically present to
execute a trade.
6. Superior Liquidity
In a forex market, traders are free to buy and sell currencies of their choosing. The
superior liquidity of the forex market allows traders to easily exchange currencies
without affecting the prices of currencies being traded.
Whether a trade is for thousand dollars or millions, trader can be assured of same
currency prices during the time an order was placed and executed. The forex
market’s superior liquidity allows them to get the profits they expect at the time they
made the trade.

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Functions of Forex Market:
The foreign exchange market performs the following important functions:
1. Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of one
currency into another, i.e., to accomplish transfers of purchasing power between two
countries. This transfer of purchasing power is performed through a variety of credit
instruments, such as telegraphic transfers, mail transfers, bank draft and foreign bills.
In performing the transfer function, the foreign exchange market carries out payments
internationally by clearing debts in both directions simultaneously, analogous to
domestic clearings.
2. Credit Function:
Another function of foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Bills of exchange used in the international
payments normally have a maturity period of three months. Thus, credit is required for
that period to enable the importer to take possession of goods, sell them and obtain
money to pay off the bill.
3. Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange risks.
Hedging means the avoidance of a foreign exchange risk. In a free exchange market
when exchange rate, i.e., the price of one currency in terms of another currency,
change, there may be a gain or loss to the party concerned. Under this condition, a
person or a firm undertakes a great exchange risk if there are huge amounts of net
claims or net liabilities which are to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market
provides facilities for hedging anticipated or actual claims or liabilities through
forward contracts in exchange. A forward contract which is normally for three months
is a contract to buy or sell foreign exchange against another currency at some fixed
date in the future at a price agreed upon now.

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No money passes at the time of the contract. But the contract makes it possible to
ignore any likely changes in exchange rate. The existence of a forward market thus
makes it possible to hedge an exchange position.
Forex Rates: (also called as exchange rate)
An exchange rate is the price of a nation’s currency in terms of another currency. Thus,
an exchange rate has two components, the domestic currency, and a foreign currency,
and can be quoted either directly or indirectly. In a direct quotation, the price of a unit
of foreign currency (also base currency) is expressed in terms of the domestic currency
(counter currency). In an indirect quotation, the price of a unit of domestic currency is
expressed in terms of the foreign currency. Exchange rates are quoted in values against
the US dollar. However, exchange rates can also be quoted against another nation's
currency, which is known as a cross currency, or cross rate. An exchange rate has
a base currency and a counter currency.
Arbitrage:
Arbitrage is the process of a simultaneous sale and purchase of currencies in two or

more foreign exchange markets with an objective to make profits by capitalizing on the
exchange-rate differentials in various markets.
In other words, Arbitrage is basically buying a security in one market and

simultaneously selling it in another market at a higher price, profiting from the
temporary difference in prices. This is considered risk-free profit for the
investor/trader.
People who engage in arbitrage are called arbitrageurs – such as a bank or brokerage
firm. The term is mainly applied to trading in financial instruments, such as bonds,
stocks, derivatives, commodities and currencies.
Spot Rate
The spot rate is the most common figure investors and travelers encounter. It’s the rate
of exchange for immediate – on the spot – trades, as opposed to trades scheduled to go
through at a point in the future. Spot trades have a two-business-day transaction time,
but the rate is still set on the day the trade is initiated.

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Forward Rate
Exchanges that are planned in the present, but are actually executed at some point in
the future, are carried out at the forward rate. The rate is set at the time the exchange is
planned, and it’s usually a few points above or below the spot rate, depending on how
the market thinks the currency will be valued in the future. Forward rates offer a good
way to hedge against losses that can occur from currency fluctuations, as buyers can
lock in a price and know exactly how much a trade will cost them down the road.
Multiple Rates
Some countries employ different rates depending on the entities involved in the
exchange. These currency systems often have a two-tier setup with floating rates for
trades conducted by private commercial entities and fixed rates for exchanges
involving “essential” or governmental bodies, including importers and exporters. Rates
for vital entities also are often higher to encourage these kinds of transactions.
Cross Rate
A cross rate is an exchange rate of two currencies expressed in a third different

currency, such as the exchange rate between the euro and the yuan expressed in yen.
In short, the cross rate refers to the exchange rate between two currencies, each of
which has an exchange rate quote against a common currency.
In other words, cross rates are the relation of two currencies against each other, based
on the rate of each of them against a third currency. For example, the Bank of England
sells or purchases Euros for yen. To calculate the cross rate of the EURJPY, the bank
will use the dollar quotes for the two pairs, EURUSD and USDJPY.
Forex Quotations
The exchange rate quotation states the number of units of a price of currency that can
be bought in terms of one unit of another currency. Foreign exchange quotations
generally follow two conventions. The two methods are referred to as the Direct
(American) and Indirect (European) method of quotation.
a) Direct quotations are also known as American quotes and it is the most common
way of stating a foreign exchange quotation in terms of the number of units of home
currency needed to buy one unit of foreign currency. For example, if the Indian Rupee

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is the home currency and the foreign currency is the dollar, then the exchange rate is
stated as: $1 = Rs.69.50 which means one dollar can buy 69.50 rupees.
b) Indirect quotations are also known as European quotes. It refers to the price of
foreign currency in terms of one unit of home currency. For example, the exchange rate
between the dollar and the rupee will be stated as: Re.1 = $0.564 which means one
rupee can buy 0.56 dollars (or 56 cents).
Forward Premiums and Discounts
Forward rates typically differ from spot rates for any given currency, that reflects a
premium or discount on the currency.
If the forward rate is higher than the existing spot rate in the forward market, the
currency is trading at a forward premium. If the forward rate is lower than the existing
spot rate in the forward market, the currency is trading at a forward discount.
The formula for this calculation is: (on the basis of 30 days = 1n)
Premium / Discount = {(FR – SR) / SR} x (12 / n) x 100
Example1: The following foreign exchange quotations are given for a 90 day contract,
where SR = $0.8576 per £ and FR = $0.8500 per £. Calculate the premium or discount
on an annualized basis.
Solution: SR = $0.8576 / £ and FR = $0.8500 / £
Forward Discount = {(0.8500 – 0.8576) / 0.8576} x 4 x 100 = 3.54% p.a.
Example2: The Danish Kroner is quoted in New York at $0.18536 / DKr Spot,
$0.18524 / DKr 30 days forward and $0.18510 / DKr 90 days forward. Calculate the
premium or discount on the Kroner.
Solution: Premium / Discount = {(FR – SR) / SR} x (12 / n) x 100
Case1 = 30 days forward

Premium / Discount = {(0.18524 – 0.18536) / 0.18536} x (12 / 1) x 100 = -9.37% p.a.
Case2 = 90 days forward
Premium / Discount = {(0.18510 – 0.18536) / 0.18536} x (12 / 3) x 100 = -0.56% p.a.

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Spread Forward Transactions
A forward spread is the price difference between the spot price of a security and the
forward price of the same security taken at a specified interval. Another name for
forward spread is forward points or pips. The formula is the forward price minus the
spot price.
For example: The spot price of the security is 1.02. The forward price, taken one month
later, is 1.07. Therefore, the forward spread is 0.05, or 5 basis points. A basis point is
one-hundredth of a point. 100 basis points equal 1% or 0.01. The wider the spread, the
more valuable the underlying asset is in the future. The narrower the spread, the more
valuable it is now. Narrow spreads, or even negative spreads, might result from short-
term shortages.
Spot Forward Transactions
In finance, a spot contract, spot transaction, or simply spot, is a contract of buying or

selling a commodity, security or currency for immediate settlement (payment and
delivery) on the spot date, which is normally two business days after the trade date.
The settlement price (or rate) is called spot price (or spot rate). A spot contract is in
contrast with a forward contract or futures contract where contract terms are agreed
now but delivery and payment will occur at a future date.
Nostro and Vostro Accounts
Nostro and Vostro are Italian terms that describe the same bank account. "Nostro" and
"Vostro" are two different terms used to describe the same bank account. The terms are
used when one bank has another bank's money on deposit, typically in relation to
international trading or other financial transactions.
For example, Bank A uses Nostro account to refer to its account that’s held by Bank B.
Nostro means “our”. It’s a shorthand way of saying, “our money that is on deposit at
your bank”. Bank B refers to Bank A’s account that it holds as a Vostro account.
Vostro means “your” and it’s a way to say, “Your money that is on deposit at our
bank”. A Vostro account can be either a company’s or an individual’s.
Both banks in the venture must record the amount of money being stored by one bank
on behalf of the other bank. The terms Nostro and Vostro are used to differentiate
between the two sets of accounting records kept by each bank. It is similar to an

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individual keeping a detailed record of every payment in and out of his or her bank
account so that she/he knows the balance at any point in time.
Banks in the United Kingdom and the United States often hold a Vostro account on
behalf of a foreign bank. The Vostro account is held in the currency of the country
where money is on deposit. A Nostro account is the record of the bank whose money is
at another bank. Nostro accounts are often used to simplify trade and foreign exchange
transactions.
In normal usage:
 A Nostro account will be in foreign currency (it is a record of funds held by a

bank in another country in the currency of that country) i.e. a bank in Country A
keeping a record of money held by a bank in Country B, in the currency of Country
B.
 A Vostro account will be in the local currency of the bank where the money is
being held i.e. it is the bank in Country B's record of the money kept by the bank
from Country A with it.
Bid Price, Ask Price and Spread in Foreign Exchange Quotation
Interbank quotations are given as a Bid and Ask (or Offer) price. A Bid is the price
(i.e. the exchange rate) in one currency at which a dealer will buy another currency. An
Offer (or Ask) is the price at which a dealer will sell the other currency. Dealers
generally Bid (buy) at one price and Offer (sell) at a slightly higher price, making their
profit from the spread, i.e. the difference between the buying and selling prices.
For example: A dealer in New Delhi may give the following quotation:
US $1 = Rs.43.3000 / 43.7300
This means that the dealer will buy dollars from the exporter at US $1 = Rs.43.3000
and sell dollars to an importer at US $1 = Rs.43.7300. The difference is the spread.
Exercise: (to work out). A foreign exchange trader gives the following quotes for the
Belgian Franc Spot, one month, three months and six months to a US based treasurer:
$0.02368 / 70 4/5 8/7 14/12
Calculate the outright quotes for one, three and six months forward.
Conversion of Direct Quote to Indirect Quote

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There are two ways to quote a currency pair, either directly or indirectly. A direct
currency quote is simply a currency pair in which the domestic currency is the
quoted currency; while an indirect quote, is a currency pair where the domestic
currency is the base currency. So if you were looking at the Canadian dollar as the
domestic currency and U.S. dollar as the foreign currency, a direct quote would be
USD/CAD, while an indirect quote would be CAD/USD. The direct quote varies the
domestic currency, and the base (or foreign currency) remains fixed at one unit. In the
indirect quote, the foreign currency is variable and the domestic currency is fixed at
one unit.
Example1: If Canada is the domestic currency, a direct quote would be 1.18 USD /
CAD and means that US $1 will purchase C$1.18. The indirect quote for this would be
the inverse (1/1.18), 0.85 CAD/USD, which means with C$1, you can purchase
US$0.85.
Example2: Euro Bid and Ask prices on the Japanese Yen are quoted direct in Paris at
Euro 0.007745/¥ and Euro 0.007756/¥ Ask. What are the corresponding indirect
quotes for Euros?
Indirect quotes are: 129.1156¥/Euro and 128.9324¥/Euro (i.e. 1/0.007745)
Calculation of Cross Currency Rates

A cross exchange rate is mostly used when the currency pair being traded does not
involve the US Dollar. The reason behind it is that conventionally if one wanted to
convert a non-USD currency into another non-USD currency, the process requires you
to convert it first to USD then converting the USD into the currency of preference.
This involves quoting conventions for currency pairs, especially in the spot forex
market. For every currency pair, there is the base currency (on the left) and the quote
currency (on the right). Few examples of currency abbreviations as per ISO are USD
(US dollars), CAD (Canadian dollars), GBP (British Pounds), INR (Indian Rupees),
EUR (Euros), CHF (Swiss Franc), JPY (Japanese Yen), CNY (Chinese Yuan) etc.
Example1: In the case of the GBP/CHF. The bid prices are as follows:
GBP/USD=1.5700, USD/CHF=0.9300.
Thus the cross rate (GBP/CHF) will be 1.5700*0.9300 = SFr 1.4601 (for 1 pound).

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Example2: In the case of the EUR/JPY. The bid prices for the yen–dollar and euro–
dollar rates are ¥78.56 and €0.7801, respectively. The euro–yen exchange rates are:
¥ / $ = 78.56 per dollar and € / $ =0.7801 per dollar. The cross rate for € / ¥ is:
Or
The euro–yen exchange rate = €0.0099 per yen or €1 = ¥101.0101
Example3: To calculate the cross-rate between the Canadian Dollar (CAD) and the
South African Rand (ZAR), using the US Dollar as the common currency. The prices
quoted are: USD/CAD = C$1.5885, USD/ZAR = R11.0500. Calculate ZAR / CAD.
The cross rates for ZAR / CAD = (USD/ZAR) ÷ (USD/CAD) = (11.0500) ÷ (1.5885) =
ZAR6.956 per CAD (or 11.0500 * 0.6295 = 6.956)
Example4: If USD is used as the base or quote currency of both pairings. When this is
the case, reciprocal paring is done where one of the currencies is flipped. To illustrate:
The bid price for EUR/GBP is £1.2440, and the bid price for USD/GBP is 1.8146. It
means €1 = £1.2440 or £1= €0.8038 (1/1.2440). To get the cross rate, we can multiply
the EUR/USD rate and USD/GBP rate, i.e. 1/1.2440*1.8146 = £1.4587 per euro. It is
same as: EUR/GBP = 1.8146/1.2440 = £1.4587 per euro.
Covered interest arbitrage
The most common type of interest rate arbitrage is called covered interest rate
arbitrage, which occurs when exchange rate risk is hedged with a forward contract.
Since a sharp movement in the forex market could erase any gains made through the
difference in exchange rates, investors agree to a set currency exchange rate in the
future in order to erase that risk. Thus, covered interest arbitrage is a strategy in which
an investor uses a forward contract to hedge against exchange rate risk. In other words,
covered interest arbitrage is an arbitrage trading strategy whereby an investor
capitalizes on the interest rate differential between two countries by using a forward
contract to cover (eliminate exposure to) exchange rate risk.
Using forward contracts enables arbitrageurs such as individual investors or banks to

make use of the forward premium (or discount) to earn a riskless profit from
discrepancies between two countries' interest rates. The opportunity to earn riskless
profits arises from the reality that the interest rate parity condition does not constantly

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hold. When spot and forward exchange rate markets are not in a state of equilibrium,
(i.e. the interest rate not being the same) the investors will invest in whichever currency
offers a higher rate of return. Economists have discovered various factors which affect
the occurrence of deviations from covered interest rate parity and the fleeting nature of
covered interest arbitrage opportunities, such as differing characteristics of assets,
varying and the transaction costs associated with arbitrage trading strategies. Covered
interest arbitrage is only possible if the cost of hedging the exchange risk is less than
the additional return generated by investing in a higher yielding currency.
Two-Point Arbitrage
It is an arbitrage transaction involving buying a currency in one market and selling it at

a higher price in another market. This is to make a riskless profit out of currency
dealing in forex market. It is a two currency cross rate.
Example: A bank in Zurich (Switzerland) gives a spot quotation against dollar as:
USD/CHF = 1.4954/1.4962, which means to Bid (buy) $1 = CHF1.4954 and to Ask
(sell) $1 will fetch CHF1.4962. At the same time, a bank in New York (US) gives a
spot quotation as: CHF/USD = 0.6695/0.6699. This transaction involves one million
Swiss francs. Is there an arbitrage opportunity?
Suppose a broker/dealer buys one million Swiss francs against dollars from the Zurich
bank and sells them to the New York bank. This would result in paying the Zurich
bank $668717 to buy one million Swiss francs (i.e. 1, 000,000/1.4954). But in New
York, the bank will give $0.6695 for every CHF it purchases. Thus, one million Swiss
francs can be sold to New York bank which is acquired from Zurich bank due to
arbitrage advantage. Hence, to sell one million Swiss francs in New York bank, will
fetch $669500 (i.e. 1, 000,000 x 0.6695) and there is a gain of $783.
Three-Point Arbitrage
It is an arbitrage transaction involving spot quotes of buying or selling two currencies

against a common currency in one market and buying or selling it at a higher price of
base currency in another market. This is also to make a riskless profit of home
currency dealing in forex market. It is three currency cross rate.
Example: A New York bank is currently offering these spot quotes: USD/JPY =
110.25/111.10, which means to Bid (buy) $1 = JPY110.25 and to Ask (sell) $1 will

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fetch JPY111.10 and USD/AUD = 1.6520/1.6530. At the same time, a bank in Sydney
is quoting: AUD/JPY = 68.30/69.00. This transaction involves 100 million yen. Is
there an arbitrage opportunity?
In this example, AUD (Australian dollars) is considered as the base currency and JPY
(Japanese Yen) as the home currency. Suppose a dealer sells yen, buys US dollars and
then sell US dollars and buys Australian dollars and does these transactions in the New
York bank. He then sells the Australian dollars and buys yen in Sydney bank.
The calculations are:
¥1 sold in New York gets US $[1 / (USD/JPY) ask] = US $(1 / 111.10)

This US $[1 / (USD/JPY) ask] is sold against Australian dollars buy in New York,
which means
{[1 / (USD/JPY) ask] x [(USD/AUD) bid]} to get (buy) Australian dollars, is equal to:
AUD (1/111.10) x (1.6520)
Finally the amount of yen obtained by selling Australian dollars in Sydney is:
¥ {[1 / (USD/JPY) ask (N)] x [(USD/AUD) bid (N)] x [(AUD/JPY) bid (S)]} which is,
¥ (1/111.10) x (1.6520) x (68.30) = ¥1.0156.
For 100 million yen it is equal to 101.56 million yen and the gain is 1.56 million yen.
The above subscripts used are: ask = sell, bid = buy, N = New York and S = Sydney.
Purchasing Power Parity
Purchasing power parity (PPP) is an economic theory that compares different countries'
currencies through a "basket of goods" approach. So the theory that states that
the exchange rate between two countries is equal to the ratio of the currencies'
respective purchasing powers.
According to this concept, two currencies are in equilibrium or at par when a basket of
goods (taking into account the exchange rate) is priced the same in both countries.
Closely related to PPP is the law of one price (LOP), which is an economic theory that
predicts that after accounting for differences in interest rates and exchange rates, the
cost of something in country X should be the same as that in country Y in real terms.
Definition: “A method of currency valuation based on the premise that two identical
goods in different countries should eventually cost the same.” Essentially this means
that adjustments are made to exchange rates so that a product has the same price when

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sold in different countries (based on the same currency). It is a theory that says that a
basket of goods in one country should cost the same in another country once you
account for the exchange rate.
PPP exchange rates help costing but exclude profits and above all do not consider the
different quality of goods among countries. The same product, for instance, can have a
different level of quality and even safety in different countries, and may be subject to
different taxes and transport costs. It may be based on LOP, but there is the absence
of transaction costs and official trade barriers.
What is the nominal and real exchange rate?
The nominal exchange rate is defined as the number of units of the domestic currency
that can purchase a unit of a given foreign currency. It is the value of money which is
received in an exchange with another currency.
The real exchange rate is a rate which measures how many times an item of goods
purchased locally can be purchased abroad. So, it indicates the ratio of items purchased
in the domestic market to the items purchased in the foreign market.
Calculating PPP
The formula for relative PPP is:

S = P1 / P2
Where: S = the exchange rate of currency A to currency B; P1 = the cost of good “x” in
currency A; P2 = the cost of good “x” in currency B.
For example, a pack of pencil that is sold for £0.50 in London should cost $0.83 in
New York – when the exchange rate between the UK and the U.S. is 1.66 GBP/USD.
In this example both packs of pencil cost $0.83 USD (i.e. half or 0.50 x 1.66).
Uses: The purchasing power parity exchange rate serves two main functions. PPP
exchange rates can be useful for making comparisons between countries because they
stay fairly constant from day to day or week to week and only change modestly if at
all, from year to year. Second, over a period of years, exchange rates do tend to move
in the general direction of the PPP exchange rate and there is some value to knowing in
which direction the exchange rate is more likely to shift over the long run.

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International Fisher Effect
The IFE uses interest rates rather than inflation rate differential to explain the changes
in exchange rates over time. The international Fisher effect was hypothesized by
American economist Irving Fisher. The international Fisher effect is a hypothesis
in international finance that suggests differences in nominal interest rates reflect
expected changes in the spot exchange rate between countries. The hypothesis
specifically states that a spot exchange rate is expected to change equally in the
opposite direction of the interest rate differential; thus, the currency of the country with
the higher nominal interest rate is expected to depreciate against the currency of the
country with the lower nominal interest rate, as higher nominal interest rates reflect an
expectation of inflation.
The relationship between the percentage change in the spot exchange rate over time
and the differential between comparable interest rates in different national capital
markets is known as the “International Fisher Effect”.
Fisher effect simple Example

Interest Rates and Exchange Rates: International fisher effect (IFE) difference in
nominal interest rates supported by two nations’ currencies will cause an equal but
opposite change in their spot exchange rates. Nominal interest rate = Real + Inflation.
International Fisher Effect: The IFE predicts that the interest rate differential (using
nominal interest rates) is an unbiased predictor of future changes in the spot exchange
rate. Assuming, the absence of government intervention, nominal interest rate
differential should reflect expected change in exchange rate. Currency with the lower
nominal interest rate expected to appreciate relative to one with a higher nominal
interest rate
Simple Version of IFE: 𝑆 (𝑡+1) / 𝑆𝑡 = [(1 + 𝑖𝑞) / (1 + 𝑖𝑝)]; where 𝑆 (𝑡+1) is the
Spot exchange rate of currency units of Q for every one unit of currency P one year
from now and 𝑆𝑡 is the current exchange rate, 𝑖𝑝 a nd 𝑖q are the respective nominal
interest rates. In other words, IFE Spot Rate =
Current Spot Rate x (1 + INT) n / (1 + INT) n
Example1: Calculate the future spot rate for Country P when its Real interest rate (RrP)
= 4% / yr, Inflation (RiP) = 5% / yr and Country Q’s Real interest rate (RrQ) = 5% / yr,
Inflation (RiQ) = 7% / yr. The Current Exchange Rate of P = 1.5Q. To calculate:

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Nominal Rate (r + i) for P = 9% and for Q = 12%. Using the simple version of IFE: P =
1.5Q x (1.12/1.09) = 1.54Q
Example2: Current spot rate for Pounds: GBP/USD=1.5560; Annual rate of interest on
5 year Government bonds: United States = 1.07%, United Kingdom = 1.37%. Use the
IFE formula to calculate the spot pound 5 years from now: (American Term)
IFE Spot Rate = Current Spot Rate x (1 + INTUS) n / (1 + INTFC) n
IFE Spot Rate = 1.5560 x (1 + 0.0107)5 / (1 + 0.0137)5
IFE Spot Rate = 1.5560 x (1.0107)5 / (1.0137)5
IFE Spot Rate = 1.5560 x (1.05466 / 1.0704)
IFE Spot Rate = 1.5560 x 0.9853
IFE Spot Rate = 1.5331. This is the forecasted spot rate 5 years from now and the
British pound is expected to appreciate and will buy lesser amount of dollars.
Example3: Current spot rate for Japanese yen: USD/JPY=76.84; Annual rate of interest
on 2 year Government bonds: United States = 0.29%, Japan = 0.14%. Use the IFE
formula to calculate the spot yen rate 2 years from now. (European Term)
IFE Spot Rate = Current Spot Rate x (1 + INTFC) n / (1 + INTUS) n
IFE Spot Rate = 76.84 x (1 + 0.0014)2 / (1 + 0.0029)2
IFE Spot Rate = 76.84 x (1.0014)2 / (1.0029)2
IFE Spot Rate = 76.84 x (1.0028) / (1.00581)
IFE Spot Rate = 76.84 x 0.9970
IFE Spot Rate = 76.609. This is the forecasted spot rate 2 years from now and the yen
is expected to appreciate will slightly purchase more amount of dollars.
Example4: The real interest rate on South Korean government securities with one-year
maturity is 4% and the expected inflation rate for the coming year is 2%. The real
interest rate on U.S. government securities with one-year maturity is 7% and the
expected rate of inflation is 5%. The current spot exchange rate for Korean Won is $1
= W1200. Forecast the spot exchange rate one year from today.
We know that the nominal interest rate in the US is 12% (7 + 5), and in South Korea it
is 6% (4 + 2). The international Fisher effect suggests that the exchange rate will
change in an equal amount but opposite direction to the difference in nominal interest
rates (currency with the higher nominal rate will get weaker). Since the nominal
interest rate is higher in the US than in South Korea, the dollar should depreciate
relative to the South Korean Won. In other words, 1US$ will buy fewer South Korean

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Won. Using the simple IFE formula: Forward rate per 1$ = ((1+0.06) / (1+0.12)) x
W1200 = W1138
MANAGING FOREIGN EXCHANGE EXPOSURE (UNIT-5)

Definition:
Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial
risk that exists when a financial transaction is denominated in a currency other than
that of the base currency of the company.
In other words, Foreign exchange risk describes the risk that an investment’s value
may change due to changes in the value of two different currencies. It is also known as
currency risk, FX risk and exchange-rate risk.
In short, Foreign exchange risk is the possibility of a gain or loss to a firm that occurs
due to unanticipated changes in exchange rate.
Meaning:
The exchange rate volatility poses a risk, called foreign exchange risk or currency risk,
to business sector, in particular, the importers and exporters or those ones who
associate with international businesses. Exchange rate volatility is unpredictable since
there are so many factors that affect the movement of the exchange rates. The exchange
risk arises when there is a risk of appreciation of the base currency in relation to the
denominated currency (or depreciation of domestic currency). The risk is that there
may be an adverse movement in the exchange rate of the denomination currency.
Country’s Current Account / Balance of Payments:
A country’s current account reflects balance of trade and earnings on foreign

investment. It consists of total number of transactions including its exports, imports,
debt, etc. A deficit in current account due to spending more of its currency on
importing products than it is earning through sale of exports causes depreciation. Even
the balance of payments fluctuations can affect the exchange rate of a currency.
What is the difference between risk and exposure?
Foreign exchange risk (also known as currency risk) is a financial risk that exists when
a financial transaction is stated in a currency other than that of the base currency of the

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company. While a Foreign exchange exposure is the risk associated with activities that
involve a global firm in currencies other than its home currency.
Types of Exposure: There are mainly three types of foreign exchange exposures:
1) Transaction risk
A firm has transaction risk whenever it has contractual cash flows (receivables and
payables) whose values are subject to unanticipated changes in exchange rates due to a
contract being denominated in a foreign currency. To realize the domestic value of its
foreign-denominated cash flows, the firm must exchange foreign currency for domestic
currency. As firms negotiate contracts with set prices and delivery dates in the face of a
volatile foreign exchange market with exchange rates constantly fluctuating, the firms
face a risk of changes in the exchange rate between the foreign and domestic currency.
It refers to the risk associated with the change in the exchange rate between the time an
enterprise initiates a transaction and settles it. Many times, companies will participate
in a transaction regarding more than one currency. In order to meet the standards of
processing these transactions, the companies that are involved have to send any foreign
currencies involved back to the countries they came from.
2) Economic risk
A firm has economic risk (also known as operation risk) to the degree that its market
value is influenced by unexpected exchange rate fluctuations. Economic risk can affect
the present value of future cash flows. In every organization, economic risk refers to
the possibility that macroeconomic conditions will influence an investment, especially
in a foreign country. Some examples of the macroeconomic conditions are exchange
rates, government regulations, or political stability. When financing an investment or a
project, a company’s operating costs, debt obligations, and other economically
unsustainable circumstances should be thoroughly calculated in order to produce
adequate revenues in covering those investment costs.
International investments are associated with significantly higher economic risk levels
as compared to domestic investments. In international firms, economic risk heavily
affects not only investors but also bondholders and shareholders, especially when
dealing with sale and purchase foreign government bonds. Despite of the risky

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outcomes, economic risk can tremendously elevate the opportunities and profits for
investors globally.
3) Translation risk
A firm's translation risk is the extent to which its financial reporting is affected by
exchange rate movements. As all firms generally must prepare consolidated financial
statements for reporting purposes, the consolidation process for multinationals entails
translating foreign assets and liabilities or the financial statements of foreign
subsidiaries from foreign to domestic currency.
Translation risk deals with the risk of a company’s equities, assets, liabilities, or
income. Any of these can change in value because of fluctuating foreign exchange
rates. Translation risk occurs when a firm denominates a portion of its equities, assets,
liabilities or income in a foreign currency. A company doing business in a foreign
country will eventually have to exchange its host country's currency back into their
domestic currency. Foreign exchange rates are constantly fluctuating, and if exchange
rates appreciate or depreciate, significant changes in the value of the foreign currency
can occur. These significant changes in value create translation risk because it creates
difficulties in evaluating how much the currencies are going to fluctuate relative to
other foreign currencies. Translation risk is the company's financial statements of
foreign subsidiaries. The subsidiary then restates financial statement in the company's
home currency. Then the firm can now prepare their consolidated financial statements.
For example, U.S. companies must restate local Euro, Pound, Yen, etc. statements into
U.S. dollars. These foreign currencies are added to the parent's U.S. dollar-
denominated balance sheet and income statement. This accounting process is called
translation. The income statement and the balance sheet are the two financial
statements that must be translated. A subsidiary doing business in the host country
usually follows the country’s’ translation method to be used. This depends on the
subsidiary’s business operations. Subsidiaries can be characterized as either integrated
foreign entity (operates as an extension of the parent company) or self-sustaining
foreign entity (operates in the local economic environment independent of the parent
company).
Functional currency Vs Reporting currency

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The functional currency is the currency in which a company earns most of its revenues
and incurs most of its expenses (or local currency of the country in which business is
carried on). The choice of the functional currency depends on whether a foreign
subsidiary is just an extension of the parent company set up to facilitate the business of
the parent company in a foreign country or whether it is an entity with a separate
business model and revenues and expenses.
The reporting currency is the currency in which the financial statements amounts are
presented. It may be different than the function currency in which case the functional
currency financial statements must be converted to the reporting currency.
Differences between Transaction Exposure and Economic Exposure
Transaction Exposure Economic Exposure
1. Contact specific General – relates to entire investment
2. Cash flow losses due to an exchange Opportunity loss caused by an exchange
rate change are easy to compute rate change are difficult to compute
3. Firms generally have some policies to Firms generally do not have policies to
cope with transaction exposure cope with economic exposure
4. The duration of exposure is the same as The duration of exposure is the time
the time period of the contract required for restructuring of operations
like new markets, products, sources,
technology etc.
5. Relates to nominal contracts whose Relates to cash flow effects through
value is fixed in foreign currency terms changes in cost, price and volume
relationships
6. The only source of uncertainty is the There are many sources of uncertainties
future exchange rate and affects sales, price, cost etc.
7. Transaction exposure is an uncertain Economic exposure is an uncertain
domestic currency value of a cash flow domestic currency value of a cash flow
which is known and fixed in foreign whose value is uncertain even in foreign
currency terms like a B/R. currency terms like cash flows from a
foreign subsidiary
Translation methods
There are four translation methods: Current / non-current method, the monetary / non-
monetary method, the temporal method, and current rate method.

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Under the current/non-current method, all current assets and current liabilities of
foreign affiliates are translated into the parent currency at current exchange rates. All
noncurrent assets, noncurrent liabilities, and owners’ equity are translated at historical
exchange rates. This method is not popular now.
Under the monetary/non-monetary method of foreign currency translation, assets and

liabilities are classified into monetary assets and liabilities and non-monetary assets
and liabilities. Monetary assets and liabilities are those that are to be settled in future
through receipt or payment of a pre-determined units of currency. Monetary items
include cash, accounts receivable, notes receivable, investments, accounts payable,
salaries payable, taxes payable, etc. Non-monetary items include inventories, fixed
assets, etc. Monetary items (assets and liabilities) are translated at the current foreign
exchange rate while the non-monetary items are translated at historical rates.
Under the temporal method, specific assets and liabilities are translated at exchange
rates consistent with the timing of the item's creation. It is a modified version of the
monetary/non-monetary method. The difference is that, in temporal method, inventory
is usually translated at historical rate but can be translated at current rate if inventory is
shown in the balance sheet at market values.
Under the current rate method, which is the simplest and most popular method, the
firms must use the current rate to translate the assets and liabilities. All balance sheet
and income statement items are translated at the current rate, except for shareholders
equity which is translated at historical rate.
Comparison of Four Translation Methods

Current / Non Monetary / Non Temporal method Current Rate method
current method monetary method
All current assets All monetary Monetary assets All assets and
and current balance sheet and liabilities liabilities except
liabilities of foreign accounts (cash, (cash, accounts common equity are
affiliates are marketable receivable, in translated at the
translated into the securities, accounts general all current exchange rate.
parent company at receivable etc) of a liabilities and long
current exchange foreign subsidiary term loans) are
rate are translated at the translated at the
current exchange current exchange
rate rate

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All noncurrent All other (non Non monetary Common equity is

assets and monetary) balance assets (inventory translated at historical
noncurrent sheet accounts and fixed assets), exchange rates.
liabilities and (Equity capital, non monetary Any imbalance
equity capital are Land, P & M, liabilities (debt between the book
translated at Inventory etc) are capital, retained value of assets and
historical exchange translated at the earnings etc) and liabilities is recorded
rate historical exchange Equity capital are as a separate equity
rate in effect when translated at the account called the
the account was first historical exchange CTA*
recorded rates
*CTA stands for Cumulative Translation Adjustment
Problems on Translation Exposure
1) A US parent establishes a subsidiary in the year 2009 in Europe. The accounts of the
subsidiary are denominated in Euros. At the end of the year balance sheet translated at
the prevailing exchange rate of $1.00 / Euro. Now there is a 25% depreciation of the
Euro against the dollar. What is the translation loss or gain?
Calculation of translation loss or gain under the four translation methods:
Historical value = 1 and Current value of dollar = 0.75 per Euro

Assets Value in € Current / Monetary / Temporal All Current
(Euros) Noncurrent Nonmonetar in $ in $
in $ y in $
Cash and 2500 1875 1875 1875 1875
marketable
securities
Accounts receivable 2500 1875 1875 1875 1875
Inventory 2500 1875 2500 1875 1875
P&M 7500 7500 7500 7500 5625
Total Assets 15000 13125 13750 13125 11250
Liabilities
Accounts payable 2500 1875 1875 1875 1875
Short term debt 2500 1875 1875 1875 1875
Long term debt 5000 5000 3750 3750 3750
Capital 5000 5000 5000 5000 5000
CTA (625) 1250 625 (1250)

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Total Liabilities 15000 13125 13750 13125 11250
2) Farm Products is the Canadian affiliate of a US manufacturing company. Its balance

sheet, in thousands of Canadian dollars, on 1st January 2011 is shown below. On 1st
January 2011, exchange rate was C$1.60 / $.
Farm Products Balance Sheet (Thousands of C$)
Assets C$ Liabilities C$
Cash 100000 Current liabilities 60000
Account receivable 220000 Long-term debt 160000
Inventory 320000 Capital stock 620000
Net P & M 200000
Total 840000 Total 840000
st
a) Determine Farm Products accounting exposure on 1 January 2012 using current
rate method and monetary/non-monetary method.
b) Calculate Farm Products contribution to its parent’s accounting loss if the exchange
rate on 31st December 2011 was C$ 1.80 / $.
Current Rate Method

Assets C$ Exchange Conversion to
rate US $ on 1st
January 2012
Cash 100000 1.8 55555.55
Accounts receivable 220000 1.8 122222.22
Inventory 320000 1.8 177777.77
Plant & Machinery 200000 1.8 111111.11
Assets total 840000 466666.66
Liabilities
Current liabilities 60000 1.8 33333.33
Long-term debt 160000 1.8 88888.88
Capital stock 620000 1.6 387500.00
CTA (43055.55)
Liabilities total 840000 466666.66
As per current rate method:

a) Accounting exposure on 1st January 2012 is as follows:
Exposed Assets = US $ 466666.66
Exposed Liabilities = US $ 122222.21
Accounting exposure = US $ 344444.45

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Accounting loss as shown in CTA account is US $ 43055.55
Monetary / non-monetary method:

Assets C$ Exchange Conversion to US
rate $ on 1st January
2012
Cash 100000 1.8 55555.55
Accounts receivable 220000 1.8 122222.22
Inventory 320000 1.6 200000.00
Plant & Machinery 200000 1.6 125000.00
Assets total 840000 502777.77
Liabilities
Current liabilities 60000 1.8 33333.33
Long-term debt 160000 1.8 88888.88
Capital stock 620000 1.6 387500.00
CTA (6944.44)
Liabilities total 840000 502777.77
3) Indus Ltd is the wholly owned Indian subsidiary of US Company, Croft Ltd. Non-
consolidated balance sheets of both the company’s, in thousands, are as follows:
Assets Croft $ Indus Rs. Liabilities Croft $ Indus Rs.
Cash 2200 8000 Accounts pay’ble 1000 12000
Accounts rec’ble 2400 4600 Common stock 4000 6000
Inventory 2400 7000 Retained earning 8600 10600
P&M 4600 9000
Investment 2000
Total 13600 28600 Total 13600 28600
a) Croft Ltd translates (balance sheet) by current rate method. The current exchange
rate is Rs.43.20 / $.
b) Calculate the accounting exposure for Croft Ltd by the current rate method and
monetary/non-monetary method.
c) Prepare a consolidated balance sheet for Croft Ltd and Indus Ltd.
d) P & M and Common stock were acquired when exchange rate was Rs.38.20 / $.
Current Rate Method

Assets Conversio US $ Liabilities Conversio US $
n to US $ n to US $
Cash 8000/43.2 185.18 Accounts pay’ble 12000/43.2 277.77
Accounts rec’ble 4600/43.2 106.48 Common stock 6000/38.2 157.07

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Inventory 7000/43.2 162.03 Retained earning 10600/38.2 277.48

P&M 9000/43.2 208.33 CTA (50.30)
Total 662.02 Total 662.02
Accounting Exposure = 662.02 – 277.77 = 384.25

Monetary / Non-monetary Method
Assets Conversion US $ Liabilities Conversion US $
to US $ to US $
Cash 8000/43.2 185.18 Accounts pay’ble 12000/43.2 277.77
Accounts rec’ble 4600/43.2 106.48 Common stock 6000/38.2 157.07
Inventory 7000/38.2 183.25 Retained earning 10600/38.2 277.48
P&M 9000/38.2 235.60 CTA (1.81)
Total 710.51 Total 710.51
Accounting Exposure = 291.66 – 277.77 = 13.89
Consolidated Balance Sheet for Croft Ltd and Indus Ltd (translated at current rate)
Assets US $ Liabilities US $
Cash 2385.18 Accounts payable 1277.77
Accounts receivable 2506.48 Common stock 4157.07
Inventory 2562.03 Retained earning 8877.48
P&M 4808.33 CTA (50.03)
Investment 2000.00
Total 14262.02 Total 14262.02
4) ABC Ltd manufactures orange marmalade in England. It is wholly owned subsidiary

of XYZ Ltd of USA. The current exchange price is $ 1.50/£. The reporting currency
for XYZ Ltd is US dollar. From the following non-consolidated financial statement,
prepare a consolidated Balance Sheet for XYZ Ltd.
Assets XYZ in $ ABC in £ Liabilities XYZ in $ ABC in £

Cash 8000 2000 Current liabilities 22000 4000
Accounts rec’ble 10000 4000 5 year term loan --- 4000
Inventory 8000 2000 Common stock 9000 2000
P&M 10000 6000 Retained earning 9500 4000
Investment 4500 ---
Total 40500 14000 Total 40500 14000
Balance Sheet for ABC Ltd in dollars:

Assets Rat Value in Value in Liabilities Value in Value in

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e £ $ £ $
Cash 1.50 2000 3000 Current liabilities 4000 6000
Accounts receivable 1.50 4000 6000 5 year term loan 4000 6000
Inventory 1.50 2000 3000 Common stock 2000 3000
P&M 1.50 6000 9000 Retained earnings 4000 6000
Investment ---
Total Assets 14000 21000 14000 21000
Consolidated Balance Sheet for XYZ & its subsidiary ABC Ltd:
Assets Amt. in $ Liabilities Amt. in $
Cash 11000 Current liabilities 28000
Accounts receivable 16000 5 year term loan 6000
Inventory 11000 Common stock 12000
P&M 19000 Retained earnings 15500
Investment 4500
Totals 61500 61500
Tools & Techniques of foreign exchange risk management:
There are four main techniques to manage foreign exchange risk and the techniques
are: 1) Forward contracts 2) Future contracts 3) Options contract and 4) Swap.
1) Forward contracts: A forward contract is a commitment to buy or sell a specific

amount of foreign currency at a later date or within a specific time period and at an
exchange rate stipulated when the transaction is struck. The delivery or receipt of the
currency takes place on the agreed forward value date. Forward contracts are one of the
most common means of hedging transactions in foreign currencies.
A forward transaction cannot be cancelled but can be closed out at any time by the
repurchase or sale of the foreign currency amount on the value date originally agreed
upon. Any resultant gains or losses are realized on this date.
2) Future contracts: Commonly used by MNC’s as hedging instruments, future

contracts are standardized contracts that trade on organized futures markets (like
SIMEX in Singapore, IMM in Chicago etc) for a specific delivery date only.
The major differences in forward and future markets are as follows:
a) The forward contract does not have lot size and is tailored to the need of the
exporter, whereas the futures have standardized round lots.

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b) The date of delivery in forward contracts is negotiable, whereas future contracts are
for particular delivery dates only.
c) The contract cost in forward contracts is based on the bid/offer spread, whereas
brokerage fee is charged for futures trading.
d) The settlement of forward contracts is carried out only on expiration date, whereas
profits or losses are paid daily in case of futures at the close of trading.
e) Forward contracts are issued by commercial banks, whereas international monetary
markets (for example, the Chicago Mercantile Exchange) or foreign exchanges
issue futures contracts.
3) Options contract:
Foreign currency options provide the holder the right to buy or sell a fixed amount of
foreign currency at a pre-arranged price, within a given time. An option is an
agreement between a holder (buyer) and a writer (seller) that gives the holder the right,
but not the obligation, to buy or sell financial instruments at a time through a specified
date.
Thus, under an option, although the buyer is under no obligation to buy or sell the
currency, the seller is obliged to fulfill the obligation.
This provides the flexibility to the holder of a foreign currency option not to buy or sell
the foreign currency at the pre-determined price, unlike in a forward contract, if it is
not profitable. Price at which the option is exercised, i.e., at which a foreign currency is
bought or sold, is known as strike price.
There are two types of foreign currency options:

Call option gives the holder the right to buy foreign currency at a pre-determined price.
It is used to hedge future payables. Put option gives the holder the right to sell foreign
currency at a pre-determined price. It is used to hedge future receivables.
Foreign currency options are used as effective hedging instruments against exchange-
rate risks as they offer more flexibility than forward or future contracts because no
obligation is required on the part of the buyer under the currency options.
4) Currency Swap:
In order to hedge long-term transactions to currency rate fluctuations, currency swaps

are used. Agreement to exchange one currency for another at a specified exchange rate

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and agreed date is termed as currency swap. Currency swaps between two parties are
often intermediated by banks or large investment firms. Foreign exchange swap
accounts for about 55.6 per cent of the average daily foreign exchange turnover of the
world, whereas spot deals account for 32.6 per cent and outright forward for 11.8 per
cent.
Meaning of commodity swap
It is different from a currency swap. A commodity swap is a type of swap agreement

whereby a floating (or market or spot) price based on an underlying commodity is
traded for a fixed price over a specified period. The vast majority of commodity swaps
involve oil.
Difference between speculation and hedging:
Speculation involves trying to make a profit from a security's price change, whereas
hedging attempts to reduce the amount of risk, or volatility, associated with a security's
price change.
Swap Contracts
A swap is a foreign currency contract whereby two parties exchange equal initial
principal amounts of two different currencies at the spot rate. The buyer and seller
exchange interest payments in their respective swapped currencies over the term of the
contract. At maturity, the principal amount is re-swapped at a pre-determined exchange
rate.
Factors that affect Forward Rates
It is understood that a forward margin is the difference between the spot rate and
forward rate of a currency, making the forward currency cheaper or costly as compared
to the spot currency. The difference in the rate of interest prevailing at different
financial centre is a major factor determining forward margin. Other factors that affect
forward margin are demand and supply of currency, speculation about spot rates and
exchange control regulations.
a) Rate of Interest:

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The difference in the rate of interest prevailing at the home centre and the concerned
foreign centre determines the forward margin. If the rate of interest at the foreign
centre is higher than that prevailing at the home centre, the forward margin would be at
discount. Conversely if the rate of interest at the foreign centre is lower than that at the
home centre, the forward margin would be at premium.
b) Inflation Rates:
Changes in market inflation cause changes in currency exchange rates. A country with
a lower inflation rate than another country inflation rate will see an appreciation in the
value of its currency. A country with a consistently lower inflation rate will depict a
rising currency value while a country with higher inflation typically sees depreciation
in its currency.
c) Demand and Supply:
The demand for and supply of foreign currency to a great extent determines the
forward margin. In the foreign exchange market if the demand for foreign currency is
more than its supply, forward rate would at premium. On the other hand if the supply
exceeds the demand then the forward rate would be at discount.
d) Speculation about Spot Rates:
The spot rates form the basis for determining forward rates. And therefore, any
speculation about spot rates would influence forward rates also. If the exchange dealers
anticipate the spot rate to appreciate, the forward rate would be quoted at premium. If
they expect the spot rate to depreciate, the forward rate would be quoted at a discount.
e) Exchange Regulations:
Exchange control regulations enforced by the governments of the nations also

influences the forward margin. And these regulations may put some conditions on the
forward dealings and may obstruct the influence of the other factors on the forward
margin. Such restrictions may include keeping of balances abroad, borrowing overseas
etc. Intervention in the forward market by the central bank may also be done to
influence the forward margin.

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Management of Translation Exposure: There are two ways to manage the same,
perhaps by hedging. A hedge is an investment that protects your finances from a risky
situation. Hedging is done to minimize or offset the chance that your assets will lose
value. It also limits your loss to a known amount if the asset does lose value. It's
similar to home insurance.
Balance sheet hedging: Balance sheet hedging is a corporate treasury method used by
businesses operating with foreign currencies to reduce the potential impact of exchange
rate fluctuations in their balance sheet.
Hedging balance sheet items involve complying with accounting standards, which
compel the company to recognize the changes in the value of the hedge contract as
well as the changes in the underlying asset on the balance sheet. The values of both the
hedged asset and the hedging instrument have to be translated into the functional
currency using the current spot exchange rate at every reporting period.
Derivatives hedging: Most investors who hedge use derivatives. These are financial
contracts that derive their value from an underlying real asset, such as a
stock. An option (to buy or sell) is the most commonly used derivative. It gives you the
right to buy or sell a stock at a specified price within a time frame.
Diversification is another hedging strategy. You own an assortment of assets

(portfolio) that don't rise and fall together. If one asset collapses, you don't lose
everything. For example, most people own bonds to offset the risk of stock ownership.
When stock prices fall, bond values increase. That only applies to high-grade corporate
bonds or U.S. Treasury’s. The value of junk bonds falls when stock prices do because
both are risky investments.
Meaning of forward market hedge
Forward market hedging is a means by which to protect exposure in the forward

currency, interest rate and financial markets.
Concept of hedging with an example
A hedge is an investment to reduce the risk of adverse price movements in an asset.

Normally, a hedge consists of taking an offsetting position in a related security. In
other words, hedging is strategically using financial instruments in the market to offset

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any investment risk by an adverse movement of price. So, hedging, for the most part, is
a technique by which a trader or investor will not make money but by which he can
reduce potential loss. Thus, hedging helps in mitigating unanticipated loss. Hedging
makes transactions, cash flows and cost structures more stable and predictable.
One way to understand hedging is to think of it as insurance. When people decide to

hedge, they are insuring themselves against a negative event. This doesn't prevent a
negative event from happening, but if it does happen and when we are properly
hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and
we see it every day. For example, if we take property insurance, we are hedging
ourselves against fires, break-ins (burglary) or other unforeseen disasters.
Tools for Hedging Foreign Exchange Risk:
The different tools for hedging against foreign exchange risk usually involve contracts
for exchanging currency at a fixed rate at some point in the future.
a) Forward Contracts
Forward contracts, or forwards, specify an amount, exchange rate and date for a
currency exchange between two parties. Forwards allow parties to close deals and plan
at current rates.
b) Futures Contracts
Futures contracts, or futures, are financial instruments with conditions for a currency
exchange, including the amount, rate and expiry date. They are available in the market
and can be traded like other financial assets. Futures eliminate the non-compliance risk
of forwards, so they are common when there are credit risks.
c) Debt Operations
Debt operations involve borrowing foreign currency. An investor borrows currency in
the amount they expect to receive in the future. Then they exchange it into local
currency and deposit it, hedging exchange rate risks. When the investor receives
foreign currency, they use it to pay the debt.
d) Leading and Lagging

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In international finance, leads and lags refer to the expediting or delaying respectively,
of settlement of payments or receipts in a foreign exchange transaction because of an
expected change in exchange rates. A change in exchange rates can be a cause of loss
(or gain) in international trade, thus the settlement of debts is expedited or delayed in
an attempt to minimize the loss or to maximize the gain. In the leads and lags, the
premature payment for goods purchased is called a "lead," while the delayed payment
is called a "lag.
e) Caps
A Cap is a paper hedge agreement designed to protect trader from rising prices, yet
allows them to benefit from falling prices. It is also known as "call option".
What is LIBOR?
LIBOR, the acronym for London Interbank Offer Rate, is the global reference rate for
unsecured short-term borrowing in the interbank market. It acts as a benchmark for
short-term interest rates.
Management of Transaction Exposure:
A company engaging in cross-currency transactions can protect against transaction

exposure by hedging. By using currency swaps, by using currency futures, or by using
a combination of these hedging techniques, the company can protect against the
transaction risk by purchasing foreign currency. Use any one of these techniques to fix
the value of the cross-currency contract in advance of its settlement.
For example, a domestic company signs a contract with a foreign company. The
contract states that the domestic company will ship 1,000 units of product to the
foreign company and the foreign company will pay for the goods in 3 months with
1000 units of foreign currency. Assume the current exchange rate is: 1 unit of domestic
currency equals 1 unit of foreign currency. The money the foreign company will pay
the domestic company is equal to 1000 units of domestic currency.
The domestic company, the one that is going to receive payment in a foreign currency,
now has transaction exposure. The value of the contract is exposed to the risk of
exchange rate fluctuations.

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The next day the exchange rate changes and then remains constant at the new exchange
rate for 3 months. Now one unit of domestic currency is worth 2 units of foreign
currency. The foreign currency has devalued against the domestic currency. Now
the value of the 1000 units of foreign currency that the foreign company will pay the
domestic company has changed – the payment is now only worth 50 units of domestic
currency.
The contract still stands at 1000 units of foreign currency, because the contract
specified payment in the foreign currency. However, the domestic firm suffered a 50%
loss in value.
Methods by which transaction exposure can be hedged
The most common methods for hedging transaction exposures are:

a) Forward Contracts b) Futures Contracts c) Money Market Hedge d) Options
Management of Economic Exposure:
Economic Exposure Management is the set of methods companies can use to handle
economic risk, also known as operational risk. This is the potential impact of adverse
exchange rate fluctuations on a company’s cash flow and competitive position.
Unlike transaction and translation exposure, economic exposure is longer-term and

therefore more difficult to forecast and hedge. The risks of operating or economic
exposure can be alleviated either through operational strategies or currency
risk mitigation strategies.
Operational strategies
a) Diversifying production facilities and markets for products: Diversification would

mitigate the risk inherent in having production facilities or sales concentrated in one or
two markets.
b) Sourcing flexibility: Having alternative sources for key inputs makes strategic sense,
in case exchange rate moves make inputs too expensive from one region.
c) Diversifying financing: Having access to capital markets in several major nations

gives a company the flexibility to raise capital in the market with the cheapest cost of
funds.

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Currency risk mitigation strategies
a) Matching currency flows: This is a simple concept that requires foreign currency
inflows and outflows to be matched. For example, if a U.S. company has significant
inflows in euros and is looking to raise debt, it should consider borrowing in euros.
b) Currency risk-sharing agreements: This is a contractual arrangement in which the

two parties involved in a sales or purchase contract agree to share the risk arising from
exchange rate fluctuations. It involves a price adjustment clause, such that the base
price of the transaction is adjusted if the rate fluctuates beyond a specified neutral
band.
c) Back-to-back loans: Also known as a credit swap, in this arrangement two

companies located in different countries arrange to borrow each other’s currency for a
defined period, after which the borrowed amounts are repaid. As each company makes
a loan in its home currency and receives equivalent collateral in a foreign currency, a
back-to-back loan appears as both an asset and a liability on its balance sheets.
d) Currency swaps: This is a popular strategy that is similar to a back-to-back loan but
does not appear on the balance sheet. In a currency swap, two firms borrow in the
markets and currencies where each can get the best rates, and then swap the proceeds.
Risk Management Products:
In a recent survey, Kurt Jesswein, Chuck Kwok and William Folks documented the
extent of knowledge and use of foreign exchange risk management products by US
corporations. Based on a survey, they found that the traditional forward contract is the
most popular product. The next commonly used instruments were foreign currency
swaps and over-the-counter options. The risk management products can be exhibited as
follows:
Type of product Heard of (percent) Used (percent)

Forward contracts 100 93.1
Foreign currency swaps 98.8 52.6
Foreign currency futures 98.8 20.1
Foreign traded currency options 96.4 17.3
Foreign traded futures options 95.8 8.9
Over-the-counter currency options 93.5 48.8
Cylinder options (derivatives ) 91.2 28.7

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Synthetic forwards 88 22
Synthetic options 88 18.6
Forward exchange agreements 81.7 14.8
Foreign currency warrants 77.7 4.2
Marketing Management of Exchange Risk:
a) Market Selection:
A major strategic consideration for a firm is what market to sell in and the relative
marketing support to devote to each market. For example, firms may decide to pull out
of markets that have become unprofitable due to real exchange rate changes, and more
aggressively pursue market share or expand into new markets when the real Exchange
rate depreciates. Market selection and market segmentation provide the basic
parameters within which a company can adjust its marketing mix over time.
b) Pricing Policies:
As we saw previously, in response to changes in real exchange rates, a firm has to
make a decision regarding market share versus profit margin. This involves the pass-
through decision with respect to the foreign currency price of foreign sales. Of course,
such a decision should be made by setting the price that maximizes dollar profits to the
firm. The decision on how to adjust the foreign currency price in response to exchange
rate changes will depend upon how long the real exchange rate change is expected to
persist, the extent of economies of scale that occur from maintaining large quantity of
production, the cost structure of expanding output, the price elasticity of demand, and
the likelihood of attracting competition if high unit profitability is apparent. The longer
the exchange rate change is expected to persist, the greater the price elasticity of
demand, the greater are the economies of scale and the greater is the possibility of
attracting competition, the greater will be the incentive to lower home currency price
and expand demand in light of a home currency depreciation, and to keep home
currency price fixed and maintain demand in light of a home currency appreciation.
c) Promotional Strategies:
An essential issue in any marketing program is the size of the promotional budget for
advertising, selling and merchandising. These budgets should explicitly build in
exchange rate impacts. An example is European ski areas in the mid 1980s. When the
dollar was strong, they found that they obtained larger returns on advertising in the
U.S. for ski vacations in the Alps as the costs compared to the Rocky Mountains has
fallen due to the currency movements.

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d) Product Strategies:
Companies can also respond to exchange rate changes by altering their product
strategy, which deals with such areas as new product introduction like:
 Product line decisions – depending upon home currency devaluation or

appreciation , a firm can change its product line and target customers
 Product innovations – for industrial rather than consumer market
Production Management of Exchange Risk:
a) Diversifying Operations:
One possibility to dealing with the impact of exchange rate exposure on the firm's cash
flows is to have the firm diversify into activities with offsetting exposures to the
exchange rate. For example, combine the production and exporting of a manufactured
good with an importing operation that imports competitive consumer goods from
foreign producers.
b) Diversifying Sources of Inputs:

For firms going in for optimization, the goal of a production strategy should be to
reduce operating costs. The most flexible way to do this in light of a real home
currency appreciation is to purchase more components from overseas. This practice is
called as outsourcing. Outsourcing gives the company flexibility of shifting those
purchases of immediate inputs towards suppliers least affected by exchange rate
changes.
c) Plant Location:
The most obvious way to be able to take advantage of relative costs changes due to real
currency movements is to have production costs based in different currency by actually
having production capacity in different countries. The simplest response is to move
production to your competitors market. Then any relative cost advantage he may gain
from exchange rate changes also accrues to you as well. Alternatively, placing a plant
in a third country based upon the intensity of certain inputs to production (i.e., labor,
raw materials) may make more sense; however one needs to think about the
correlations between the third country exchange rate and the foreign competitor's
exchange rate to evaluate the hedge value of such an decision.
d) Raising Productivity:

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Raising productivity through closing inefficient plants, automating heavily and

negotiating wage and benefit cutbacks and work rule concessions is another alternative
to manage economic exposure. Employee motivation can also be used to increase
productivity and improve product quality.
MULTINATIONAL WORKING CAPITAL MANAGEMENT (UNIT-6)

Meaning: Working capital is a common measure of a company's liquidity, efficiency,
and overall health. Because it includes cash, inventory, accounts receivable, accounts
payable, the portion of debt due within one year, and other short-term accounts, a
company's working capital reflects the results of a host of company activities,
including inventory management, cash management, debt management, revenue
collection and payments to suppliers. Positive working capital generally indicates that a
company is able to pay off its short-term liabilities almost immediately. Negative
working capital generally indicates a company is unable to do so.
Definition: Multinational working capital management is the management of

current assets and current liabilities of any multinational company who has large
number of branches and subsidiaries in different countries. In other words, we manage
the inventory, accounts receivable, cash, our short term investments, our creditors and
currency exchange risks. By managing this, multinational company can reduce its cost
and increase the money for paying day to day expenses.
What is the meaning of cash management? It is an important aspect of working

capital management. It refers to a broad area of finance involving the collection,
handling, and usage of cash. It involves assessing market liquidity, cash flow, and
investments.
In other words, cash management is the corporate process of collecting and managing
cash, as well as using it for short-term investing. It is a key component of a company's
financial stability and solvency.
In the real world, organizations have strict cash management controls to monitor its
inflows and outflows while retaining a sufficient amount in order to take advantage of
attractive investments or handle unforeseen liabilities. Efficient management of cash
prevents loss of money due to theft or error in processing transactions. Numerous best
practices (techniques) are adopted to enhance management of company’s funds.

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Such practices involves (techniques) shortening of cash collection periods, regular

follow ups for collections, negotiation of favorable terms with suppliers allowing delay
in payment periods, and preparation of cash flow forecasts. Businesses also use of
technology to speed up cash collection process. They must do all of this while
maintaining adequate amount of funds to meet daily operations.
What is cash planning?
Cash planning is a technique to plan and control the use of cash. It is to plan for the
requirements of operations of business and to meet the firm’s objectives. Cash
planning may be prepared on the daily, weekly, monthly or quarterly basis.
Objectives of effective international cash management
The primary objective of cash management is to utilize cash as efficiently as possible in

a manner consistent with a company's overall strategic objectives. Major objectives of
cash management include:
1. Maintaining Liquidity - Liquidity refers to a company's ability to meet upcoming

obligations in a timely and cost effective manner.
2. Optimizing Cash Resources - Cash managers establish systems that reduce holdings
of non-earning cash balances to minimum levels while still providing adequate liquidity.
Any excess cash balances are either invested to generate additional income or used to
reduce interest expense through the repayment of debt.
3. Financing - Cash managers assist in obtaining both short- and long-term borrowed
funds in a timely manner and at an acceptable cost. These credit facilities are used to
fund a company's cash shortages.
4. Managing Risk - Cash managers help in the monitoring and controlling of a
company's exposure to interest rate, foreign exchange, and other risks.
5. Coordinating Financial Functions - Cash managers help ensure that managers in other
areas of the company understand and implement policies that are consistent with cash
management objectives.
6. To make Payment according to Payment Schedule - Firm needs cash to meet its
routine expenses including wages, salary, taxes etc. At the same time adequate cash
helps to prevent firm from being insolvent, ensure the relation of firm with bank does
not deteriorate, and contingencies can be met easily.

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Reasons for holding cash:
Firms with strong growth opportunities and high levels of R&D

expenditures hold more cash. This is consistent with a precautionary motive for
holding cash, according to which firms with high future investment needs hold more
cash in order to guarantee that they will not have to give up on future opportunities.
Netting: The settlement of obligations between two parties that processes the combined
value of transactions is netting. It is designed to lower the number of transactions
required. For example, if Bank A owed Bank B $100,000, and Bank B owed Bank A
$25,000, the value after netting would be a $75,000 transfer from Bank A to Bank B.
Netting is a technique of optimizing cash flow movements with the joint efforts of
subsidiaries and is typically used by companies with a number of affiliates in different
countries. Netting allows parties to reduce their exposures and consequently reduce their
risk.
In financial terms, it is referred to as a method of reducing credit, settlement and other

risks of financial contracts by aggregating (combining) two or more obligations to
achieve a reduced net obligation.
Example of netting: A US parent company has subsidiaries in France, Canada, UK and

Japan. The amounts due to and from the affiliated companies is converted into a
common currency (the US $). The French subsidiary owes the Canadian subsidiary
$60000, the UK subsidiary $80000 and the Japanese subsidiary $100000. As against
this, for the same period, the French subsidiary is due to receive $40000 from the
Canadian subsidiary, $60000 from the UK subsidiary and $100000 from the Japanese
subsidiary. The other inter-subsidiary transactions are shown as below:
Inter-subsidiary netting matrix (US $ thousands)

Paying affiliate
Receiving France Canada UK Japan Total
France --- 40 60 100 200
Canada 60 --- 40 80 180
UK 80 60 --- 70 210
Japan 100 30 60 --- 190
Total 240 130 160 250 780
Netting Schedule (US $ thousands)

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Country Receipt Payment Net Receipt Net Payment

France 200 240 40
Canada 180 130 50
UK 210 160 50
Japan 190 250 60
Without netting, the total payments would equal $780 thousands; multinational netting
reduces these transfers to $100 thousands, a net reduction of 87%. It is economical and
also reduces the currency conversion costs.
Investing excess cash: Another important function of international cash management is

investing excess cash. The Eurocurrency market helps in investing and accommodating
excess cash in the international money market. This also yields a higher rate than bank
deposits in the United States. Eurocurrency market is also used by MNCs many times as
a temporary use of funds. In addition, foreign treasury bills and commercial paper can
also be purchased by the MNCs. It is also better for MNCs to adopt a centralized cash
management strategy whereby excess funds with the individual subsidiaries are pooled
together. Pooling funds together allows for more efficient use of funds and possibly
higher returns due to larger deposits. With excess cash, it is also worthwhile for an
MNC to diversify its portfolio of securities across countries with different currency
denominations because the MNC is not very sure as to how exchange rates will change
over time. This way the MNC will reduce its exposure to excessive exchange rate risk in
any single currency and it will avoid the possibility of incurring substantial loss of a
particular currency’s depreciation. Overall the companies must adopt suitable and
judicious investment opportunities to invest excess cash.
Problem: A US multinational firm maintains a multilateral inter-affiliate netting system,

with netting operations conducted by a currency centre, which is also in-charge of
investing the excess cash resources of all affiliates. The data is given below:
Affiliate Amounts due to Funds available Funds required for

other affiliates Operations July 15 –
31, 2010
Position as of July 15, 2010
Affiliate A (£) FF 2,000,000 to B
DM 3,500,000 to C £10,000,000 £5,200,000
Affiliate B (FF) £1,500,000 to A
DM 2,000,000 to C FF 27,000,000 FF 48,000,000

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Affiliate C (DM) £3,000,000 to A

FF 10,000,000 to B DM 45,000,000 DM 18,000,000
a) Devise a netting system for the firm showing amounts and currencies of actual
transfers made on July 20, 2010
b) The firm’s cash management policy requires that all cash surplus affiliates transfer
their surpluses to the center on the 15th and the last day of each month. What will be the
total resources (in US dollars) available for investment during the second half of May?
c) Outline the advantages which the firm derives from the netting plan developed. Spot
exchange rates on July 15th, 2010 were:
£1.00 = $ 1.55; $ 1.00 = FF 6.90; $ 1.00 = DM 2.75
Solution: Inter-company matrix for a US firm

Paying affiliates
Receiving affiliates A B C
A --- FF 2,000,000 DM 3,500,000
B £1,500,000 --- DM 2,000,000
C £3,000,000 FF 10,000,000 ---
a) To convert the currency of all facilities to a common currency being US dollars:
Inter-company payments matrix (US $ in hundred thousands)
Paying affiliates
Receiving affiliates A B C Total
A --- 2.90 12.73 15.63
B 23.25 --- 7.27 30.52
C 46.50 14.49 --- 60.99
Total 69.75 17.48 20.00 107.14
The netting schedule is as follows:

Receipt Payment Net receipt Net payment
Receiving affiliates
A 15.63 69.75 --- 54.12
B 30.52 17.48 13.04 ---
C 60.99 20.00 40.99 ---
b) The funds available and the funds required have been converted in to dollars:
Funds Funds Surplus Deficit

Affiliates

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available required
A 155.00 80.60 74.40
B 39.13 69.56 30.43
C 163.64 64.45 98.19
Total surplus 172.59
There is a surplus of funds with affiliates A and C. So they will send the cash surplus to
the firm and the centre depository has $ 17,259,000 which it can invest.
Affiliate B requires the local credit and a loan of $ 3,043,000.
c) The advantages of the netting plan are as follows:
 The exchange has been reduced

 The transfer costs have been reduced from $ 10,714,000 to $ 5,412,000. Thus a
reduction of 49.49%
Management on receivables:
Receivables represent amounts owed to the firm as a result of sale of goods or services
in the ordinary course of business. They form part of its current assets. Receivables are
also known as accounts receivables, trade receivables, customer receivables or book
debts. The period of credit and extent of receivables depends upon the credit policy
followed by the firm. The purpose of maintaining or investing in receivables is to meet
competition, and to increase the sales and profits.
Accounts Receivables Management denotes to make decisions relating to the

investment in the current assets as vital part of operating process, the objective being
maximization of return on investment in receivables. It can be established that accounts
receivables management involves maintenance of receivables of optimal level, the
degree of credit sales to be made, and the debtors' collection. Receivables Management
is also known as trade credit management.
The objectives of a good account receivable management are:

i) Having a proper credit policy in place (who to extend credit to, how much, and
how to monitor)
ii) Ensuring credit (policy) awareness among all teams - sales, finance etc. so that
there is no gap between policy and actual implementation

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iii) Proper customer on-boarding and data management - so that the business has
ability to know, analyse and track (credit) customers at all points of time
iv) Having an efficient invoicing and accounting process, such that internal and
external views of the receivable are aligned - to this effect - business needs to
ensure Purchase Orders are tracked, invoices are sent to right person, and sales
dues (and receipts) are properly recorded
v) Efficient Collections Follow-up Processes - despite best intent, many businesses
fail to track their receivables and follow-up with customers when they need to.
Empirical evidence suggests, that time taken to collect can be reduced by 20%-
50% with proper processes in place.
vi) Alignments of Incentives and Pricing policies - with right data and insights in
place, businesses can and should incentivize sales (& finance) teams for earlier
collections, and also seek to adjust their pricing with customers, by linking it to
their payment track record.
Inventory management:
Inventory management is basically related to task of controlling the assets that are
produced to be sold in the normal course of the firm's procedures. In short, inventory
management is the management of inventory and stock. . The significance of inventory
management to the company depends on the extent of its inventory investment.
Effective inventory management is to make good balance between stock availability
and the cost of holding inventory. As a key function, inventory management is to keep
a detailed record of each new or returned product as it enters or leaves a warehouse or
point of sale.
The objectives of inventory management are:
1. To keep inventory at sufficiently high level to perform production and sales

activities smoothly.
2. To minimize investment in inventory at minimum level to maximize profitability.
Other objectives of inventory management are:
1. To ensure that the supply of raw material & finished goods will remain continuous
so that production process is not halted and demands of customers are duly met.
2. To minimize carrying cost of inventory.

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3. To keep investment in inventory at optimum level.
4. To reduce the losses of theft, obsolescence & wastage etc.
5. To make arrangement for sale of slow moving items.
6. To minimize inventory ordering costs.
Components of inventory management:
Inventories exist in different forms in a manufacturing company. These include:

1. Raw materials: Raw materials are those inputs that are transformed into
completed goods throughout manufacturing process. These form a major input
for manufacturing a product. In other words, they are very much needed for
uninterrupted production.
2. Work-in-process: Work-in-process is a stage of stocks between raw materials
and finished goods. Work-in-process inventories are semi-finished products.
They signify products that need to undergo some other process to become
finished goods.
3. Finished products: Finished products are those products which are totally
manufactured and company can immediately sell to customers. The stock of
finished goods provides a buffer between production and market.
4. Stores and spares: It comprises of office and plant cleaning materials like soap,
brooms, oil, fuel, light, bulbs and are purchased and stored for the purpose of
maintenance of machinery.

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International Financial Management

Finance and Accounting (Christ (Deemed To Be University))

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INTERNATIONAL FINANCIAL MANAGEMENT (UNIT-1)

International Financial Management is a well-known term in today’s world and it is

International Finance is an important part of financial economics. It mainly discusses

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International Business: Globalization Overview

International financial management is a growing field with significant implications for

Multinational corporations rely on international financial management to achieve the

The Global Economy

International financial management is growing in importance as international financial

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Business opportunities, including international investments and joint ventures, in the

Emerging markets, often occurring in countries experiencing political upheaval, will

Difference between MNC and TNC

An international company is an organization that has business operations in several

Features (characteristics) of MNC’s

(i) Huge Assets and Turnover:

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(ii) International operations through a Network of Branches:

MNCs have production and marketing operations in several countries; operating

(iii) Unity of Control:

(iv) Mighty Economic Power:

(v) Advanced and Sophisticated Technology:

Generally, a MNC has at its command advanced and sophisticated technology. It

(vi) Professional Management:

A MNC employs professionally trained managers to handle huge funds, advanced

(vii) Aggressive Advertising and Marketing:

(viii) Better Quality of Products:

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(i) Employment Generation:

(ii) Automatic Inflow of Foreign Capital:

(iii) Proper Use of Idle Resources:

Because of their advanced technical knowledge, MNCs are in a position to properly

(iv) Improvement in Balance of Payment Position:

(vi) Technical Development:

(vii) Managerial Development:

MNCs employ latest management techniques. People employed by MNCs do a lot of

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(viii) End of Local Monopolies:

(ix) Improvement in Standard of Living:

(x) Promotion of international brotherhood and culture:

(i) Danger for Domestic Industries:

(ii) Repatriation of Profits:

(Repatriation of profits means sending profits to their country).

(iii) No Benefit to Poor People:

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(iv) Danger to Independence:

(v) Disregard of the National Interests of the Host Country:

(vi) Misuse of Mighty Status:

(vii) Careless Exploitation of Natural Resources:

(viii) Selfish Promotion of Alien Culture:

(ix) Exploitation of People, in a Systematic Manner:

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Importance of International Finance

International finance plays a critical role in international trade and inter-economy