Fundamentals of International Finance

FUNDAMENTALS OF INTERNATIONAL
FINANCE
1. Meaning of International Finance:
1) The study of International Finance essentially involves the study of different mechanisms by
which money can be raised in international market.

2) The main areas through which monetary resources are raised are:

(A) International equity market

(B) International debt market

(C) International loan syndication

(D) International trade credit

3) All these mechanisms in different proportions involve two additional variables beyond those
applicable to raising resources domestically. These additional variables are:

(1) The rate of conversion between currencies called the exchange rate.

(2) The rates of interest applicable to the two currencies being exchanged.

4) Thus, the study of International Finance therefore involves an understanding of International

economics and the mechanisms of Foreign Exchange arithmetic.

2. Scope of International Finance:

1) International Trade: International trade helps to achieve following:

(1) Transfer of efficiency from one geographical area to another.

(2) Improvement in the standard of living of both communities.

(3) Provides for better utilization of resources at a universal level.

2) Foreign Exchange Market: The transactions which get executed through the inter mediation
of banks where one currency gets converted into another. This process is called ‘Foreign
Exchange’.

3) International Financial Economics: It is concerned with causes and effects of financial

flows among nations.

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 Fundamentals of International Finance

4) International Financial Management: It is concerned with how individual economic units,

especially MNCs, cope with complex financial environment of international business.

5) International Financial Markets: It is concerned with international financial/investment

instruments, foreign exchange markets, international banking, international securities markets,
financial derivatives, etc.

3. Balance of Payments As Determinant of Demand for and Supply of

Currency:
1) Balance of Payments: Definition:

(1) The Balance of Payments of a country is a systematic account, in the form of summarized
record, of all economic transactions between residents of a country and non-residents over a
given period.

(2) The account is prepared using the double entry accounting system with both the debit and
credit aspects of each transaction being recorded under different heads within the account which
implies that the BOP account always balances. (i.e. Debit and Credit summations are equal)

(3) In the present context exchange rates in most major economies (exception: China) follow the
Flexible Exchange Rate System, which means that exchange rates are established through market
demand – supply equilibrium.

(4) Demand- supply of currencies is based on currency flows into and out of the economy. The
factors which contribute to such flows are:

a) Export and Import of goods and services.

b) Personal remittances.

c) Investments and Redemptions

d) Borrowings and Lendings

(5) All the above transactions pertaining to an economy over a given period are captured in BOP
account for the country.

(6) Components of the BOP account: The BOP account has three components:

A) Current Account B) Capital Account C) Reserve Account

A) Current Account:

1) The current account of the BOP is made up of three balances namely – Merchandise (Visible)
balance, Services (Invisible) balance and Unilateral Transfer Balance.
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 Fundamentals of International Finance

2) Effectively it reflects the net flow of goods, services and unilateral transfers (gifts, donations,
legacies, etc.).

3) Balance on current account can be defined as the net value of the balances of the visible trade,
invisible trade and unilateral transfers.

4) BOP on current account covers all receipts and payments arising out trade and personal
remittances. It thus has a direct impact on the exchange rate of the domestic currency.

B) Capital Account:

1) The capital account records all international transactions that involve creation of assets and
liabilities in foreign currencies.

2) The Capital account thus records all ‘receivables and payables’ which would impact the
demand - supply equilibrium in the future.

3) The classification of a transaction as either current or capital therefore does not depend on the
nature of asset but on the nature of the transaction.

C) Reserves Account:

1) Reserve account forms a special feature of the capital account. This account records the
changes in the part of the reserves of other countries that is held in the country concerned.

2) These reserves are held in three forms: in foreign currency, as gold and as Special Deposit
Receipts (SDRs).

3) The change in the reserves account measures a nation’s surplus or deficit on its current and
capital account transactions by netting reserve liabilities from reserve assets.

(7) Methods to find out Surplus OR Deficit in BOP Account:

1) Autonomous & Accommodating Capital Flows Concept:

NO. AUTONOMOUS TRANSACTIONS ACCOMODATING TRANSACTIONS

1. These transactions are undertaken in the These transactions are undertaken with the
normal course of business without specific intention of balancing the BOP.
considering the equilibrium of the BOP.

2. These transactions effectively represent These transactions effectively represent

Current and Capital account transactions. Reserve account transactions.

3. Classified as ‘Above the Lie’ transactions. Classified as ‘Below the Line’ transactions.

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 Fundamentals of International Finance

4. These transactions are normally These transactions are undertaken by the

undertaken by market participants other Central Bank.
than the Central Bank.

5. BOP is surplus if net balance of A surplus BOP result is an increase in

autonomous transactions is positive. BOP reserves whereas a deficit BOP results is a
is deficit if net balance of autonomous decrease in reserves account.
transactions is negative.

(8) Detailed Outline of the BOP Statement & Sub Accounts: BOP is a summary of all the
transactions between the residents of one country and non-residents for a given period of time,
usually one year. A BOP statement (revised) includes the following sub accounts, as shown in
the table below.

Items Credits Debits Net

A. Current Account

1. Merchandise

a. Private

b. Official

Non- monetary gold account

2. Invisibles

a. Travel

b. Transportation

c. Insurance

d. Investment Income

e. Government (not included elsewhere)

f. Miscellaneous

3. Transfer Payments (unilateral transfers)

a. Private

b. Official

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 Fundamentals of International Finance

Total Current Account (1+2+3)

B. Capital Account

1. Private

a. Short Term

b. Long Term

2. Banking

a. Short Term

b. Long Term

3. Official

a. Loans

b. Amortisation

c. Miscellaneous

Total Capital Account (1+2+3)

Errors and Omissions account

C. Reserves Account

a. IMF account

b. SDR account

c. Reserve – Monetary gold account

- Foreign Currency account

XXX XXX NIL

4. Devaluation / Depreciation of Exchange Rate:

1) Economies which operate on either a fixed exchange rate system or a Managed Float system
use the exchange rate to achieve equilibrium in international trade.

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 Fundamentals of International Finance

NO. DEVALUATION DEPRECIATION

1. Represents reduction in the value of Represents reduction in the value of the

the currency through official action. currency through market action.

2. It is one time action. It is a continuous process.

3. It cannot be predicted. It can be anticipated.

4. Associated with the fixed exchange Associated with the flexible exchange rate
rate system. system.

5.

Value

Value

Time
Time

5. Factors affecting Foreign Exchange Rates: Foreign Exchange rates are influenced
by several factors in the international market. These can be summarized as follows:

A) Gross Domestic Product (GDP): GDP is the primary indicator of the strength of economic
activity.

B) Trade Balance: This represents the difference between imports and exports of tangible
goods.

C) Inflation: Inflation is the rate of change in the price level of a fixed basket of goods and
services in an economy.

D) Employment levels: Employment levels in an economy reflect the development and stability
in the economy.

E) Exchange Rate Policy: In many countries the exchange rate policy is decided by the Finance
Ministry. However, the execution of the exchange rate policy is always managed by the Central
Bank.

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 Fundamentals of International Finance

F) Political Factors: Some of the common political developments such as elections, public
announcements by central bank or government officials, military takeovers, political instability,
etc. All such factors affect the exchange rate.

G) View of Speculators: More than 90% of the turnover in international foreign exchange
markets represents speculative activity. The view or perception of the likely value of the
currency of these participants in the market has a critical effect on the exchange rate.

Conclusion: Thus, these are some of the factors that affect the exchange rate.

6. Concepts of a foreign exchange transaction:

1) FIAT Currencies: FIAT currencies are paper currency notes issued by the Central Monetary
Authority of the respective countries, incorporating promise to redeem these notes at face value.

2) Foreign Currency: The Foreign Exchange Management Act, 1999, defines:

“Foreign Exchange means foreign currency and includes-

i. Deposits, credits and balances payable in any foreign currency.

ii. Drafts, travelers cheques, letter of credit or bills of exchange, expressed or drawn in Indian
currency but payable in any foreign currency; and

iii. Drafts, traveler’s cheques, letter of credit or bills of exchange drawn by banks, institutions or
persons outside India, but payable in Indian currency”.

3) NOSTRO accounts: Demand deposit accounts, denominated in foreign currencies

maintained by domestic banks with banks overseas are called NOSTRO accounts. Nostro means
‘our account with you’. Ex: If Bank of India, Mumbai has a US Dollar account with Citibank,
New York then such an account would be called a NOSTRO account.

4) VOSTRO accounts: Demand deposit accounts denominated in domestic currency maintained

by overseas banks with domestic banks are called VOSTRO accounts. Vostro account means
‘your account with us’. Ex: If Barclays Bank, London has an INR account with Punjab National
bank, New Delhi then such an account would be called VOSTRO account.

5) LORO accounts: The term LORO is used when the NOSTRO/VOSTRO account is referred
to, by a bank other than the account maintaining bank and the bank with which the account is
maintained. In other words, it is used when referring to third party accounts. Ex: If Bank of
India, Mumbai has an account with Citibank, New York denominated in US Dollars then when
Bank Of Baroda has to refer to this account while corresponding with Citibank, it would refer to
it as LORO Account, meaning ‘their account with you’.
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 Fundamentals of International Finance

6) Correspondent Banks: The bank with whom a nostro or vostro a/c relationship is established
is called correspondent bank. This bank essentially acts as an agent of the domestic bank
(principal) and undertakes various functions as follows:

1. Maintaining the foreign currency a/c

2. Providing temporary overdrafts as and when necessary.

3. Providing credit reports on companies located in the country of the correspondent bank.

4. Assisting the principal bank in all agency functions.

5. Providing trade related data and product data to help the principal bank.

7) Foreign Exchange: It can be defined as, a transaction or mechanism which facilitates the
exchange between one legal tender and another. It involves transfers through demand deposit
accounts at both ends of an international transaction. The actual conversion takes place through
the use of Nostro / Vostro accounts between international banks.

8) Foreign Exchange Market: The foreign exchange market can be defined as an electronically
connected network of international banks, brokers and service providers. The main
characteristics of this market are:

a) This market does not involve any physical transfer of currencies.

b) This market does not have any physical structure.

c) This market helps to establish the rate of conversion between currencies.

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