UNIT II – INTERNATIONAL FINANCIAL MANAGEMENT

Financial management is mainly concerned with how to optimally make various corporate
financial decisions, such as those pertaining to investment, capital structure, dividend
policy, and working capital management, with a view to achieving a set of given corporate
objectives. Globalization of the financial markets results in increased opportunities and
risks on account of overseas borrowing and investments by the firm.
International financial management (IFM), also known as international finance, is the
management of finance in an international business environment; that is, trading and
making money through the exchange of foreign currency.
Nature of International Financial Management:
• IFM is concerned with financial decisions taken in international business.
• IFM is an extension of corporate finance at international level.
• IFM set the standard for international tax planning and international accounting.
• IFM includes management of exchange rate risk.
Scope of International Financial Management:
• Foreign exchange markets, international accounting, exchange rate risk
management etc.
• It also includes management of finance functions of international business.
• IFM sorts out the issues relating to FDI and foreign portfolio investment.
• It manages various risks such as inflation risk, interest rate risks, credit risk and
exchange rate risk.
• Investment and financing across the nations widen the scope of IFM to international
accounting standards.
Features of IFM:
• Foreign exchange risk: Variability of exchange rates is widely regarded as the
most serious international financial problem facing corporate managers and policy
makers.
• Political risk: It the risk of losing money due to changes that occurs in a country’s
government. Political actions and instability may make it difficult for companies to
operate. Acts of war, terrorism, trade barriers and military coups are all extreme
examples of political risk.
• Expanded opportunity sets: Firms can raise funds in capital markets where cost
of capital is the lowest. Firms can also gain from greater economies of scale when
they operate on a global basis.
• Market imperfections: There are profound differences among nations’ laws, tax
systems, business practices and general cultural environments. At least one of the
assumptions for perfect competition is violated and out of this is comes what we
call an imperfect market
Significance of IFM:
▪ International finance helps in calculating exchange rates of various currencies of
nations and the relative worth of each and every nation in terms thereof.
▪ It helps in comparing the inflation rates and getting an idea about investing in
international debt securities.

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 ▪ It helps in ascertaining the economic status of the various countries and in judging
the foreign market.
▪ International Financial Reporting System (IFRS) facilitates comparison of financial
statements made by various countries.
▪ It helps in understanding the basics of international organizations and maintaining
the balance among them.
▪ International finance organizations such as IMF, World Bank etc. mediate and
resolve financial disputes among member nations.
Participants of IFM:
• Banks: It is wider than the Securities Market and embraces all forms of lending and
borrowing, whether or not evidenced by the creation of a negotiable financial
instrument. Banks take an active part in bond markets. They may invest in equity
and mutual funds as a part of their fund management.
• Insurance Companies: The principal aims of the participants are to show the
causes of institutional growth, the nature of institutional investors and the
implications of their activities and growth. The participants draw on material from
interviews with fund managers, econometric and statistical analysis, and studies of
the individual countries’ financial sectors.
• Primary Dealers (PDs): They are a firm that buys government securities directly
from a government, with the intention of reselling them to others, thus acting as a
market maker of government securities. The government may regulate the behavior
and number of its primary dealers and impose conditions of entry.
• Stock Exchanges: They are a series of exchanges where successful corporations
go to raise large amounts of cash to expand. Stocks are shares of ownership of a
public corporation that are sold to investors through broker-dealers. The investors
profit when companies increase their earnings.
• Custodians: They are a specialized financial institution responsible for
safeguarding a firm’s or individual’s financial assets and is not engaged in
“traditional” commercial or consumer/retail banking such as a mortgage or personal
lending, branch banking, personal accounts, and Automated Teller.
• Brokers: They usually arrange loans for a fee. They deal with the lenders for you
and arranges a loan. They help build up order book, price discovery and are
responsible for a contract being honored. For their services, brokers earn a fee
known as brokerage.
• Financial Institutions: Organizations and institutions in the public and private
sectors also often sell securities on the capital markets in order to raise funds. FIs
raise their resources through long-term bonds from the financial system and
borrowings from international financial institutions like International Finance
Corporation.
• Depositories: Deposits can also come in the form of securities such as stocks or
bonds. On instructions of stock exchange clearing house, supported by
documentation, a depository transfers securities and settlement from buyers to
sellers’ accounts in electronic form.
• Merchant Banks: A financial institution that specializes in services such as issue
management, international trade financing, long term loans and management of
investment portfolios.

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Objectives of IFM:
❖ Basic Goals:
o Wealth Maximization of Shareholders: Effective and efficient
management of the firm’s resources along with good investment decisions
will result in achieving high standards in the organization. This will lead to
an increase in revenue with higher profits. This will in turn maximize the
wealth of the shareholders by higher value generation, increasing the stock
price as well as higher dividends pay-out.
o Profit Maximization: International financial management aims to
maximize the profits of the organization by making correct investment
decisions. It promotes investments that are safe and will generate good
returns. Also, the utilization of funds should be such that the activities of the
company go on without interruption. This will result in an increase in
turnover and thus, profits.
❖ Secondary Objectives:
o Optimum Rate of Interest: International financial management aims to
achieve an optimum rate of interest on the funds that a company borrows.
The managers should check and compare all the possible options of finance
that a company has. They should choose the source that is reliable, safe, and
with the least possible rate of interest. Lower interest or lower financing
costs will boost the profits in turn.
o Foreign Exchange Risk Management: As we all know foreign
exchange risk is an essential and important part of international trade.
Hence, managers have no choice but to manage foreign exchange rate risk
timely and effectively. Exchange rates are volatile and unpredictable. They
can result in gains as well as heavy losses in case they are not favourable for
the company. Hence, the managers should adequately consider, cover, and
hedge against foreign exchange risk while doing international trade.
o Political Risk Management: The management should take into account
cases of political unrest or instability in countries before they invest there.
Changes in laws and policies of the government, or a change in the
government itself can create trouble for any company. They may face
cancellations of projects or hindrances, red-tapism, and delays that may
cause significant monetary losses to the company. Hence, the managers
should always take political risk into consideration while investing in any
project, especially if it is for the long term.
o Effectively Use Expanded Sets of Opportunities: International financial
management aims to make the best possible use of opportunities that arise
from investing in different countries. Interest rates and the cost of
capital can be very low in some countries. Some foreign markets may have
the extra potential for a particular line of product. The managers should be
dynamic and flexible in this fast-changing business environment. They
should immediately make use of any of such opportunities that may arise
and result in monetary benefits for the company.
o Proper Tax Planning: International financial management aims to promote
tax planning in the best possible way. Different countries have different tax
slabs, liabilities, and exemptions. Managers should be efficient enough to

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 study in detail the taxation policies of all of the countries wherever they
operate. The management should avoid any wastage of resources on account
of inefficient tax planning. Maximum possible reduction in tax liabilities
needs to be done by making use of government tax exemptions, rebates, or
any other benefits that are available.
o Effective Inflation Risk Management: Another goal of international
financial management is to effectively manage the inflation risk that may
arise in different countries at different times. Inflation or the continuous rise
in prices of inputs can cause a major financial strain on any company.
Managers need to properly plan and budget for inflation risk by properly
studying the economic environments of countries where they operate. This
will help them to get their costing and pricing right and minimize instances
of losses for the company.
o Maximization of Shareholder Value: International financial management
aims to maximize shareholder value by ensuring the maximum possible
dividend pay-out. This can happen by ensuring that the company performs
well. The managers have to manage the company’s finances in the most
effective and efficient manner so as to increase the net profits of the
company. They may retain a smaller portion of profits for investment or
expansion purposes. They can decide to postpone heavy capital
expenditures for some time and give a higher dividend pay-out.

BALANCE OF PAYMENTS
Balance Of Payment (BOP) is a statement which records all the monetary
transactions made between residents of a country and the rest of the world
during any given period. It accounts for transactions by businesses, individuals,
and the government.
Definition of BOP- “The Balance of Payments of a country is a systematic
accounting record of all economic transactions during a given period of time
between the residents of the country and residents of foreign countries.”
It represents an accounting of a country's international transactions for a period,
usually a quarter or a year. When all the elements are correctly included in the
BOP, it should sum up to zero in a perfect scenario. This means the inflows and
outflows of funds should balance out.
The balance of payments is a summary of transactions between domestic and
foreign residents for a specific country over a specified period of time. It
accounts for transactions by businesses, individuals, and the government.

A balance-of-payments statement can be broken down into various components.

Those that receive the most attention are the current account, the capital
account, and the official reserves account. For all three accounts, transactions
that reflect inflows of funds generate positive numbers (credits) for the country's
balance whereas transactions that reflect outflows of funds generate negative
numbers (debits) for its balance.

The BOP is a standard double-entry accounting record and as such is subject to

all the rules of double entry book-keeping viz. for every transaction two entries

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 must be made, one credit (+) and one debit (-), the total of credits must exactly
match the total of debits i.e. the balance of payments must always "balance".

The BOP's accounting principles regarding debits and credits can be

summarised as follows:
1. Credit Transactions (+) are those that involve the receipt of payment from
foreigners. The following are some of the important credit transactions:
a. Exports of goods or services
b. Unilateral transfers (gifts) received from foreigners
c. Capital inflows
2. Debit Transactions (-) are those that involve the payment of foreign
exchange i.e., transactions that expend foreign exchange. The following are
some of the important debit transactions:
a. Import of goods and services
b. Unilateral transfers (or gifts) made to foreigners
c. Capital outflows
3. Capital Inflows can take either of the two forms:
a. An increase in foreign assets of the nation
b. A reduction in the nation's assets abroad
4. Capital Outflows can also take any of the following forms:
a. An increase in the nation's assets abroad
b. A reduction in the foreign assets of the nation

Components of BOP:

❖ Current Account
The main components of the current account are payments for (1)
merchandise (goods) and services, (2) factor income, and (3) Unilateral
transfers.
Entries in this account are "current" in value as they do not give rise to future
claims. A surplus in the current account represents an inflow of funds while
a deficit represents an outflow of funds. The main components of the current
account are :
❖ Payments for Goods and Services: Merchandise exports
and imports represent tangible products, such as computers
and clothing, that are transported between countries. Service
exports and imports represent tourism and other services
(such as legal, insurance, and consulting services) provided
for customers based in other countries. The difference
between total exports and imports is referred to as the
Balance of Trade (BoT). A deficit in the Indian balance of
trade means that the value of merchandise and services
exported by the India is less than the value of merchandise
and services that it imports.
❖ Factor Income Payments: A second component of the
current account is factor income, which represents income
(interest and dividend payments) received by investors on
foreign investments in financial assets (securities). Thus,
factor income received by Indian investors reflects an inflow

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 of funds into India. Factor income paid by Indian securities
reflects an outflow of funds from India.
❖ Unilateral transfers: These are gifts and grants by both
private parties and governments. Private gifts and grants
include personal gifts of all kinds. Government transfers
include money, goods and services sent as aid to other
countries.

❖ Capital Account
The capital account includes the value of financial assets transferred across
country borders by people who move to a different country. This account
consists of loans, investments, other transfers of financial assets and the
creation of liabilities. The capital account can be divided into three
categories:
❖ Direct investment - occurs when the investor acquires equity such
as purchases of stocks, the acquisition of entire firms, or the
establishment of new subsidiaries.
❖ Portfolio investments - represent sales and purchases of foreign
financial assets such as stocks and bonds that do not involve a
transfer of management control. Investors generally feel that they
can reduce risk more effectively if they diversity their portfolio
holdings internationally rather than purely domestically.
❖ Capital flows - represent the third category of capital account and
represent claims with a maturity of less than one year. Such claims
include bank deposits, short-term loans, short term securities, money
market investments and so forth. These investments are quite
sensitive to both changes in relative interest rates between countries
and the anticipated change in the exchange rate.

❖ Official Reserves Account

Official reserves are government owned assets. The official reserve account
represents only purchases and sales by the central bank of the country (e.g.,
the Reserve Bank of India). The changes in official reserves are necessary
to account for the deficit or surplus in the balance of payments.
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 and
SDRs or borrow fresh from foreign central banks. However, if a country has
a BOP surplus, its central bank will either acquire additional reserve assets
from foreigners or retire some of its foreign debts.
Features of BOP:
• It is a systematic record of all economic transactions between one country
and the rest of the world.
• It includes all transactions, visible as well as invisible.
• It relates to a period of time. Generally, it is an annual statement.

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 • It adopts a double-entry book-keeping system. It has two sides: credit side
and debit side. Receipts are recorded on the credit side and payments on the
debit side.
• When receipts are equal to payments, the balance of payments is in
equilibrium; when receipts are greater than payments, there is surplus in the
balance of payments; when payments are greater than receipts, there is
deficit in the balance of payments,
• In the accounting sense, total credits and debits in the balance of payments
statement always balance each other.

Significance of BOP:
• It displays the financial or economic position of the country in the world.
• It helps in forming the nation’s monetary, fiscal and trade policies.
• As far as the national income is concerned, it tells the contribution of foreign
trade and transaction to it.
• It is useful to the banking sector, industries, financial institutions and
individuals who are directly or indirectly engaged in international trade and
financial activities.
• It is an economic barometer of a country’s growth vis-à-vis the rest of the
world.

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