MODULE 07: INTERNATIONAL FINANCIAL

ENVIRONMENT

❖ EXCHANGE RATES AND CURRENCIES IN INTERNATIONAL BUSINESS

• A currency is a form of money and a unit of exchange.

• Each country prefers using its own unique currency, which complicates international business
transactions.
• Cross-border transactions occur through an exchange of these currencies between buyers and
sellers.
• The exchange rate—the price of one currency expressed in terms of another—varies over
time.
• Currencies appreciate (go up in value) and depreciate (go down in value) relative to other
currencies.
• Exchange rate fluctuations and similar complications in international business create currency
risk, the potential harm that can arise from changes in the price of one currency relative to
another.
• If you buy from a supplier whose currency is appreciating against yours, you may need to pay
a larger amount of your currency to complete the purchase. Currency risk also arises if you
expect payment from a customer whose currency is depreciating against your own.
• If the foreign currency fluctuates in your favor, you may gain a windfall.

❖ CONVERTIBLE AND NONCONVERTIBLE CURRENCIES

• A convertible currency can be easily exchanged for other currencies. The most easily
convertible are called hard currencies and include the British pound, European euro, Japanese
yen, and U.S. dollar. They are strong, stable currencies that are universally accepted and used
most often for international transactions. Nations prefer to hold hard currencies as reserves
because of their relative strength and stability in comparison to other currencies.
• A currency is nonconvertible when it is not acceptable for international transactions. Some
governments may not allow their currency to be converted into a foreign currency. They
prevent this conversion to preserve their supply of hard currencies, such as the euro or the
U.S. dollar, or to avoid the problem of capital flight. Capital flight is the rapid sell-off by
residents or foreigners of their holdings in a nation’s currency or other assets. This usually
occurs in response to a domestic crisis that causes them to lose confidence in the country’s
economy. The investors exchange their holdings in the weakening currency for those of
another, often a hard currency. Capital flight from a country diminishes its ability to service
debt and pay for imports.

❖ FOREIGN EXCHANGE MARKET

• Foreign exchange represents all forms of money that are traded internationally, including
foreign currencies, bank deposits, checks, and electronic transfers. Foreign exchange resolves
the problem of making international payments and facilitates international investment and
borrowing among firms, banks, and governments.
• Currencies such as the euro, yen, and U.S. dollar are traded on the foreign exchange market,
the global marketplace for buying and selling national currencies.
 • Factors influencing Foreign Exchange Market include:
i. Economic Factors (economic policy, economic indicators, fiscal policy, monetary
policy, government surplus / deficits, inflation, economic growth, etc.)
ii. Political Factors (domestic & international political conditions, political stability)
iii. Market psychology and trader’s perception

❖ FUNCTIONS OF FOREIGN EXCHANGE MARKET

1) Transfer Function: The basic and the most visible function of foreign exchange market is
the transfer of funds (foreign currency) from one country to another for the settlement of
payments. It basically includes the conversion of one currency to another, wherein the role of
FOREX is to transfer the purchasing power from one country to another. Example: If the
exporter of India import goods from the USA and the payment is to be made in dollars, then
the conversion of the rupee to the dollar will be facilitated by FOREX. The transfer function
is performed through a use of credit instruments, such as bank drafts, bills of foreign
exchange, and telephone transfers.

2) Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the
smooth flow of goods and services from country to country. An importer can use credit to
finance the foreign purchases. Such as an Indian company wants to purchase the machinery
from the USA, can pay for the purchase by issuing a bill of exchange in the foreign exchange
market, essentially with a three-month maturity.

3) Hedging Function: The third function of a foreign exchange market is to hedge foreign
exchange risks. The parties to the foreign exchange are often afraid of the fluctuations in the
exchange rates, i.e., the price of one currency in terms of another. The change in the exchange
rate may result in a gain or loss to the party concerned. Thus, due to this reason the FOREX
provides the services for hedging the anticipated or actual claims/liabilities in exchange for
the forward contracts. A forward contract is usually a three-month contract to buy or sell the
foreign exchange for another currency at a fixed date in the future at a price agreed upon
today. Thus, no money is exchanged at the time of the contract.

❖ CURRENCY RISK

• Today, 19 member states of the European Union have adopted the euro as their common
currency and sole legal tender. The countries’ use of the euro eliminates the problem of
exchange rate fluctuations in trade and investment with each other.
• Other countries in Latin America, the Caribbean, and the Middle East have opted to use a
regional or hard currency. The challenges posed by fluctuating exchange rates motivate
countries to coordinate their monetary policies. Governments attempt to manage exchange
rates by buying and selling hard currencies and by keeping inflation under control.
• However, the foreign exchange market is huge, and it shifts very quickly. Even major
governments have difficulty controlling exchange rate movements.
• Example: Implications for international business between Europe and the United States.
❖ THREE TYPES OF CURRENCY EXPOSURE (RISKS IN FOREX MARKET)

1) Transaction exposure
• It is the currency risk that firms face when outstanding accounts receivable or payable
are denominated in foreign currencies.
• Suppose Dell imports 3 million Taiwan dollars’ worth of computer keyboards and
pays in the foreign currency. At the time of the purchase, suppose the exchange rate
was US$1 = T$30, but Dell pays on credit terms three months after the purchase. If
during the three-month period the exchange rate shifts to US$1 = T$27, Dell will
have to pay an extra US$11,111 as a result of the rate change ([3,000,000/27] –
[3,000,000/30]). F
• rom Dell’s standpoint, the Taiwan dollar has become more expensive. Such gains or
losses are real. They affect the firm’s value directly by affecting its cash flows and
profit.

2) Translation exposure
• It results when an MNE translates financial statements denominated in a foreign
currency into the functional currency of the parent firm as part of consolidating
international financial results.
• Consolidation is the process of combining and integrating the financial results of
foreign subsidiaries into the parent firm’s financial records. Accounting practices
usually require the firm to report consolidated financial results in the functional
currency. Translation exposure occurs because, as exchange rates fluctuate, so do the
functional currency values of exposed assets, liabilities, expenses, and revenues.
• Translating quarterly or annual foreign financial statements into the parent’s
functional currency results in gains or losses on the date financial statements are
consolidated.
• When translated into dollars, the quarterly net income of the Japanese subsidiary of a
U.S. MNE may drop if the Japanese yen depreciates against the dollar during the
quarter.
• Note that gains or losses in translation exposure are paper, or virtual, changes and do
not affect cash flows directly. This contrasts with transaction exposure, in which
gains and losses are real.

3) Economic exposure
• Economic Exposure (also known as operating exposure) results from exchange-rate
fluctuations that affect the pricing of products and inputs and the value of foreign
investments.
• Exchange-rate fluctuations help or hurt sales by making the firm’s products relatively
more or less expensive for foreign buyers.
• If the yen appreciates against the euro, a European firm can expect to sell more goods
in Japan because the Japanese have more buying power for buying euros. But if the
yen weakens against the euro, the European firm’s sales will likely drop in Japan
unless management lowers its Japanese prices by an amount equivalent to the fall in
the yen.
• Similarly, the firm may be harmed by currency shifts that raise the price of inputs
sourced from abroad.
• The value of foreign investments can also fall, in home currency terms, with
exchange-rate changes.
 • Transaction exposure affects ongoing contractual transactions. By contrast, economic
exposure affects long-term profitability through changes in revenues and expenses.
Such effects are reflected in the firm’s financial statements.

❖ FOREX RISK MANAGEMENT: HEDGING TECHNIQUES

The basic of hedging is to create a position in foreign currency in direction opposite to one that
exists so that ultimately the balance becomes zero. Loss incurred from one position due to
exchange rate change is offset by a profit earned on opposite position on account of same
exchange rate change. Following are different external and internal methods of Hedging:

• External Methods of Hedging:

1) Forward Contract Hedge:

➢ It is most widely used form of hedging exchange rate risk. In Forward Contract, the
company arranges for disposing / selling off or acquiring foreign currency at a future
date, when it is likely to be received or paid by it at a pre-determined exchange rate.
➢ If company has realize receivables after 6 months maturity, this realizes can be sold
to the bank at forward rate agreed, irrespective of spot rate prevailing. Similarly, if
company has payable in foreign currency may buy foreign currency from the bank
and thus, determine in advance its cost in rupees.
➢ Hedger knows in advance the amount that will be realized or payable in domestic
currency instead of keep guessing what will be future rate.
 ➢ The difference between forward rate booked and actual spot rate on date of execution
of contract is known as Opportunity Cost. More the efficient market, lower the
opportunity cost and vice versa. At the time of entering into forward contract, this
cost is unascertainable.
➢ Disadvantage: Hedger cannot take advantage of any favourable changes in the
exchange rate movement. (Exporter had booked forward contract at 1 $ = ` 62, but
spot rate on maturity is 1 $ = ` Thus, ` 3 is opportunity loss incurred).

2. Currency Swaps:
➢ Refers to a transaction whereby two currencies are exchanged by the parties involved,
only to be exchanged back later. The quantity exchanged in one of the currencies
remains constant in both the legs of swap, through the quantity of second generally
changes.
➢ It is a combination of two transactions, i.e. one spot and one forward, with an
exchange of currencies taking place at pre-determined exchange rates.
➢ It is an agreement where two parties exchange a series of cash flows in one currency
for a series of cash flows in another currency at agreed intervals over an agreed
period.
➢ A company would want to do such a swap if it wants to convert its liabilities in a
particular currency to that of another currency.

• Internal Methods of Hedging:

1. Leads and Lags:

➢ Exporters and Importers makes estimates whether currency will weaken (devalued) or
strengthen (revalued) in future. Based on these expectations, they may like to fasten
or postpone the time of receipts or payment of foreign currencies. These timings of
payment of foreign currency depending on the expectations of its change in value is
known as Leads and Lags.
➢ When foreign currency is expected to be devalued, exporter will ask for payment
earlier than normal because if payment is received after devaluation, amount received
in rupee terms will be less. If currency is expected to be revalued, the importer would
like to settle debt earlier than normal because if paid before revaluation, he would be
paying less. In both the cases, exporter as well as importer is said to LEAD the
payment.
➢ When foreign currency is expected to be revalued, exporters would like to delay the
payments, because after revaluation, the value in terms of rupees would be higher. On
the contrary, when the foreign currency is expected to be devalued, importers would
like to delay the payments because, they may pay less in rupee terms. This
postponing the payments is known as LAG.

❖ ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION

• At the most basic level, exchange rates are determined by the demand and supply of one
currency relative to the demand and supply of another
• In a free market, the price of any currency—that is, its exchange rate—is determined by
supply and demand. Supply and demand adjust according to market forces.
 • Continuous shifts in the supply of and demand for dollars result in continuous changes in the
dollar exchange rate. Some currencies are pegged to fixed exchange rates and, thus, may not
respond to market forces.
• In a free market, the levels of supply and demand for a currency vary inversely with its price.
Thus, all else being equal,
i. The greater the supply of a currency, the lower its price.
ii. The lower the supply of a currency, the higher its price.
iii. The greater the demand for a currency, the higher its price.
iv. The lower the demand for a currency, the lower its price.
• It does not reveal that:
i. What factors underlie the demand for and supply of a currency
ii. When the demand for dollars will exceed the supply (and vice versa) or when the
supply of Japanese Yen will exceed demand for them (and vice versa)
iii. under what conditions a currency is in demand or under what conditions it is not
demanded.
• Economic theories of exchange will give us a deeper understanding of how exchange rates
are determined.

1. PURCHASING POWER PARITY (PPP) THEORY

• Purchasing Power Parity is an economic theory that allows comparison of the purchasing
power of the various world currencies to one another.
• It is a theoretical exchange rate that allows you to buy the same amount of goods and
services in every country.
• This theory states that, in ideally efficient markets, identical goods should have only one
price. The law of one Price (LOOP)
• The law of one price states that, in the absence of trade frictions and conditions of free
competition and price flexibility all identical goods whatever be the market must have only
one price if they are using a common currency. It assumes that there would be no tariff,
taxes, quotas. etc (a limitation to the theory)
• Example: Suppose, the one USD is equal to 70 INR. If a Toy sells for $15 in United states
while in India they sell it for 700 rupees. Since 1 USD = 70 INR, the toy which cost $15 in
US costs only $10 in India (700/70) if we buy it from India. Clearly, there is an advantage of
buying the toy in India as customers would be at gain. if the consumers will decide to do this.
We should expect to see these three things:
i. American consumers demand for Indian rupees would increase which will cause
Indian rupees to become more expensive.
ii. The demand for toy sold in US market would decrease and hence its prices would
tend to decrease.
iii. The increase demand for toy in India would make them more expensive.
• Thus, the prices in US and India would start moving towards an equilibrium.
Types of Purchasing Power Parity:

i. Absolute Purchasing Power Parity:

 It postulates that the equilibrium exchange rate between currencies of two
countries is equal to the ratio of the price levels of two nations.
 Therefore, the price of a product in country X and the price of the product in
country Y (in Y’s currency) should be such that, the ratio of the prices is the
exchange rate between the currencies of the two countries.

ii. Relative Purchasing Power Parity:

 According to relative purchasing power parity (RPPP), the difference between the
two countries’ rates of inflation and the cost of commodities will drive changes in
the exchange rate between the two countries.
 When there is an inflation, price level increases, quantity of goods that can be
purchased by one unit of currency, declines. Thus the purchasing power also
declines and vice versa. Thus, inflation/deflation affect the exchange rate.
 The difference in the rate of change in prices at the home and abroad is the
difference in the inflation rates - is equal to the percentage of depreciation or
appreciation of the exchange rate.

2. INTEREST RATE PARITY (IRP) THEORY

• According to the theory, the forward exchange rate should be equal to the spot exchange rate
times the interest rate of the home country, divided by the interest rate of the foreign country.

• Thus, the exchange rate between two currencies is purely depend upon the interest rates
prevailing in the two respective countries
• The interest rate parity presents an idea that there is no arbitrage in the foreign exchange
markets.
 • The currency with higher interest rate will suffer depreciation while currency with lower
interest rate will appreciate
• In an efficient money and capital market in existence within the two countries, the exchange
rates will adjust in such a way that it will bring the parity in the interest rate, and in turn
remove the possibility of any arbitrage opportunity.
• Using the interest rate parity can have many advantages because it can be used to predict the
forward exchange rate of currencies, can be used to represent no-arbitrage state, and can also
be used to describe the relationship between interest rates and exchanges rates of two
countries.

3. INTERNATIONAL FISHER EFFECT

• The International Fisher Effect (IFE) is an economic theory stating that the expected disparity
between the exchange rate of two currencies is approximately equal to the difference between
their countries' nominal interest rates.
• The International Fisher Effect (IFE) states that differences in nominal interest rates between
countries can be used to predict changes in exchange rates.
• According to the IFE, countries with higher nominal interest rates experience higher rates of
inflation, which will result in currency depreciation against other currencies.

❖ FOREIGN DIRECT INVESTMENT

• FDI means investment in a foreign country where the investor retains control over the
investment.
• FDI implies that the investor exerts a significant degree of influence on the management of
the enterprise in other country. It normally takes the form of starting a subsidiary, acquiring a
stake in the existing firm or starting a joint venture in the foreign country. Since FDIs cannot
be easily liquidated, these are governed by long-term considerations. So the FDI decisions are
affected by the following factors:

➢ Political stability
➢ Government policy
➢ State of economic development,
➢ Industrial prospects, etc.

• The differences between FDIs and FPI are shown in figure 7.1