International Financial Management

Course Code: MG20M304

UNIT 1
The International Financial Environment: A Historical
Perspective
The international financial environment has undergone a dramatic transformation over the
centuries, evolving from a relatively isolated system to an increasingly interconnected global
marketplace. This evolution has been driven by a confluence of factors, including
technological advancements, economic liberalization, and political developments.

Key Historical Milestones:

• The Gold Standard (1870-1914): This system, characterized by the convertibility of

currencies into gold, provided a stable international monetary framework. However,
the outbreak of World War I led to its suspension.
• The Interwar Period (1919-1944): This period witnessed significant economic
instability, marked by the Great Depression and protectionist policies. The Bretton
Woods Agreement, established in 1944, sought to address these issues by creating the
International Monetary Fund (IMF) and the World Bank.
• The Bretton Woods Era (1944-1971): Under this system, the U.S. dollar served as
the global reserve currency, convertible into gold at a fixed rate. However, the system
eventually collapsed due to increasing U.S. deficits and a loss of confidence in the
dollar.
• The Floating Exchange Rate Era (1971-Present): Since the collapse of Bretton
Woods, most major currencies have been allowed to float freely against each other,
determined by market forces. This system has increased exchange rate volatility but
has also provided greater flexibility for countries to manage their economies.

Financial Globalization: Openness of the Indian Economy

Financial globalization refers to the increasing integration of financial markets across
national borders. This process has been driven by factors such as technological
advancements, deregulation, and the liberalization of capital flows. India has witnessed a
significant degree of financial globalization in recent decades.

Indicators of Openness of the Indian Economy:

• Capital Account Liberalization: India has gradually liberalized its capital account,
allowing foreign investors to invest in Indian securities, real estate, and businesses.
• Foreign Direct Investment (FDI): India has attracted substantial FDI inflows,
particularly in sectors such as technology, manufacturing, and services.
 • Remittances: India receives significant remittances from its diaspora, which
contribute to its balance of payments and economic growth.
• Trade Liberalization: India has reduced trade barriers through measures such as
lowering tariffs and reducing non-tariff barriers.
• Integration into Global Financial Markets: Indian financial institutions have
become increasingly integrated into global financial markets, participating in
international transactions and raising funds from foreign investors.

International Financial Transactions

International financial transactions involve the exchange of goods, services, assets, or

liabilities between residents of different countries. These transactions can be broadly
categorized into:

• Merchandise Trade: The import and export of goods.

• Services Trade: The provision of services across borders, such as tourism,
transportation, and financial services.
• Income Transactions: The transfer of income, such as interest, dividends, and
wages, between residents of different countries.
• Capital Transfers: The transfer of capital, such as investments, loans, and grants,
between residents of different countries.

Balance of Payments (BoP)

The balance of payments is a systematic record of all economic transactions between a
country and the rest of the world over a given period (usually a year). It provides a
comprehensive overview of a country's economic performance and its interactions with other
countries.

Structure of the Balance of Payments

The BoP is typically divided into three main accounts:

1. Current Account: This account records transactions related to the current flow of
goods, services, income, and unilateral transfers.
o Trade Balance: The difference between exports and imports of goods and
services.
o Income Balance: The difference between income earned from foreign sources
and income paid to foreign residents.
o Current Transfers: The net transfer of resources between residents of a
country and residents of foreign countries without a corresponding exchange
of goods or services.
2. Capital Account: This account records transactions related to the transfer of
ownership of non-financial assets, such as fixed assets and intangible assets.
3. Financial Account: This account records transactions related to the acquisition and
disposal of financial assets and liabilities, such as investments, loans, and deposits.
Balancing the BoP

In theory, the balance of payments should always be in balance, meaning the total of all
credits (exports, income received, capital inflows) should equal the total of all debits
(imports, income paid, capital outflows). However, in practice, there may be statistical
discrepancies or errors that result in a small surplus or deficit.

Note: The balance of payments is a key indicator of a country's economic health. A persistent
deficit may signal that a country is consuming more than it produces or borrowing
excessively from foreigners. Conversely, a persistent surplus may indicate that a country is
saving too much or not investing enough domestically.

The Importance, Rewards, and Risks of International

Finance
International finance is the study of financial transactions and relationships between
countries. It plays a crucial role in the global economy, facilitating trade, investment, and
economic growth.

Importance of International Finance

• Economic Growth: International finance promotes economic growth by allowing

countries to access foreign markets, obtain capital, and transfer technology.
• Trade and Investment: International finance enables countries to engage in
international trade and investment, leading to increased efficiency and productivity.
• Risk Management: International finance provides tools and strategies for managing
risks associated with international transactions, such as exchange rate fluctuations and
political instability.

Rewards of International Finance

• Profitability: International operations can be highly profitable due to lower labor

costs, access to new markets, and economies of scale.
• Diversification: Operating in multiple markets can reduce risk by diversifying
revenue streams.
• Innovation: Exposure to different cultures and business practices can foster
innovation and creativity.

Risks of International Finance

• Exchange Rate Risk: Fluctuations in exchange rates can impact the profitability of
international transactions.
• Political Risk: Political instability, changes in government policies, and trade barriers
can create risks for international businesses.
• Cultural Risk: Differences in cultural values, business practices, and communication
styles can pose challenges for international operations.
Goals of Multinational Corporations (MNCs)
MNCs are businesses that operate in multiple countries. Their goals often include:

• Profit Maximization: MNCs strive to maximize profits by leveraging their global

presence and economies of scale.
• Market Expansion: MNCs seek to expand their market share by entering new
geographic regions.
• Resource Acquisition: MNCs may acquire resources, such as raw materials or skilled
labor, that are not readily available in their home country.
• Risk Reduction: MNCs can reduce risks by diversifying their operations across
different markets.

International Business Methods

MNCs employ various methods to conduct their international business, including:

• Exporting and Importing: The simplest form of international business involves

exporting goods or services to foreign markets or importing goods from foreign
suppliers.
• Licensing and Franchising: Licensing involves granting a foreign company the right
to use a company's intellectual property, while franchising involves granting a foreign
company the right to use a company's business model and brand.
• Foreign Direct Investment (FDI): FDI involves investing in a foreign country by
acquiring a controlling interest in a local company or establishing a new subsidiary.
• Strategic Alliances and Joint Ventures: Strategic alliances and joint ventures
involve partnering with foreign companies to share resources, expertise, and risks.

Exposure to International Risk

MNCs are exposed to various international risks, including:

• Exchange Rate Risk: Fluctuations in exchange rates can impact the profitability of
international transactions.
• Political Risk: Political instability, changes in government policies, and trade barriers
can create risks for international businesses.
• Cultural Risk: Differences in cultural values, business practices, and communication
styles can pose challenges for international operations.
• Economic Risk: Economic downturns, inflation, and recession can affect the demand
for a company's products or services in foreign markets.
International Monetary System
The international monetary system refers to the rules and institutions that govern international
currency exchange. The current system is based on floating exchange rates, where the value
of a currency is determined by market forces.

Multilateral Financial Institutions

Multilateral financial institutions are international organizations that provide financial
assistance to developing countries. Examples include:

• International Monetary Fund (IMF): The IMF provides loans to countries

experiencing balance of payments difficulties.
• World Bank: The World Bank provides loans and grants for development projects.
• Asian Development Bank (ADB): The ADB provides financial assistance to
countries in Asia and the Pacific.
UNIT 2
International Flow of Funds and the International Monetary
System

International Flow of Funds

The international flow of funds refers to the movement of money,

investments, and financial assets across national borders. This flow is
driven by various factors, including trade, investment, financial
transactions, and remittances.

Balance of Payments (BoP)

The balance of payments (BoP) is a systematic record of all economic

transactions between a country and the rest of the world over a given
period (usually a year). It provides a comprehensive overview of a
country's economic performance and its interactions with other
countries.

Fundamentals of BoP

• Accounting Identity: The BoP is always in balance, meaning

the total of all credits (exports, income received, capital inflows)
must equal the total of all debits (imports, income paid, capital
outflows).
• Current Account: This account records transactions related to
the current flow of goods, services, income, and unilateral
transfers.
• Capital Account: This account records transactions related to
the transfer of ownership of non-financial assets.
• Financial Account: This account records transactions related to
the acquisition and disposal of financial assets and liabilities.
Accounting Components of BoP

1. Current Account:
o Trade Balance: The difference between exports and
imports of goods and services.
o Income Balance: The difference between income earned
from foreign sources and income paid to foreign
residents.
o Current Transfers: The net transfer of resources between
residents of a country and residents of foreign countries
without a corresponding exchange of goods or services.
2. Capital Account:
o Capital Transfers: The transfer of non-financial assets,
such as fixed assets and intangible assets.
3. Financial Account:
o Direct Investment: Investments made by a resident in a
foreign country to control a business enterprise.
o Portfolio Investment: Investments in foreign financial
assets, such as stocks and bonds, that do not involve
controlling ownership.
o Financial Derivatives: Contracts that derive their value
from an underlying asset.
o Other Investment: Other financial transactions not
classified as direct or portfolio investment.

The International Monetary System

The international monetary system is the framework that governs

international currency exchange. It provides the rules and institutions
that facilitate the exchange of goods, services, and capital across
borders.

• Key Components:
o Exchange Rates: The value of one currency relative to
another.
o Reserve Currencies: Currencies held by central banks as
reserves to settle international payments.
 o International Monetary Fund (IMF): A multilateral
institution that promotes international monetary
cooperation and provides financial assistance to countries
in need.

Factors Affecting International Trade and Capital Flows

Several factors influence international trade and capital flows:

Economic Factors

• Comparative Advantage: Countries tend to specialize in producing goods and

services in which they have a comparative advantage, leading to trade.
• Economic Growth: Economic growth in one country can increase demand for
imports from other countries.
• Income Levels: Higher income levels in a country often lead to increased demand for
imports.
• Exchange Rates: Fluctuations in exchange rates can affect the competitiveness of
exports and imports.

Political Factors

• Trade Policies: Tariffs, quotas, and subsidies can restrict or promote international
trade.
• Political Stability: Political instability can deter foreign investment and trade.
• Trade Agreements: Regional and bilateral trade agreements can facilitate trade.

Technological Factors

• Transportation Costs: Advances in transportation technology can reduce the cost of

transporting goods.
• Communication Technology: Improved communication technology can facilitate
international trade and investment.

Other Factors

• Cultural Factors: Differences in cultural preferences and tastes can influence

international trade.
• Demographic Factors: Population growth and aging can affect demand for goods
and services.
Agencies that Facilitate International Flows
• World Trade Organization (WTO): The WTO oversees international trade rules
and settles trade disputes.
• International Monetary Fund (IMF): The IMF promotes international monetary
cooperation and provides financial assistance to countries in need.
• World Bank: The World Bank provides financial assistance to developing countries
for infrastructure and development projects.
• Regional Development Banks: These banks, such as the Asian Development Bank
(ADB) and the Inter-American Development Bank (IDB), provide financial assistance
to countries in specific regions.

Balance of Payments (BOP), Equilibrium, and

Disequilibrium
• Equilibrium: A country's BOP is in equilibrium when its total exports equal its total
imports.
• Disequilibrium: A country's BOP is in disequilibrium when its total exports do not
equal its total imports. This can lead to a trade surplus or deficit.
• Trade Deficit: A trade deficit occurs when a country imports more goods and
services than it exports. It can be financed by borrowing from other countries or by
drawing down foreign exchange reserves.

Factors Affecting Trade Deficits

• Exchange Rates: A weak domestic currency can make exports more competitive and
imports more expensive, potentially reducing trade deficits.
• Economic Growth: Faster economic growth in a country can lead to increased
demand for imports, contributing to a trade deficit.
• Consumer Preferences: Consumer preferences for foreign goods and services can
contribute to trade deficits.
• Government Policies: Fiscal and monetary policies can affect trade deficits.

Capital Account Convertibility and Balance of Payments

(BOP) Problems
Capital account convertibility refers to the freedom of residents and non-residents to
convert domestic currency into foreign currency and vice versa for capital transactions. While
capital account convertibility can promote economic growth and development, it can also
lead to BOP problems.

BOP problems arise when a country's exports do not equal its imports, resulting in a surplus
or deficit. A surplus can lead to inflation and a deficit can lead to currency depreciation and
economic instability.

Factors that can lead to BOP problems due to capital account convertibility include:
 • Excessive capital inflows: If a country attracts excessive capital inflows, it can lead
to appreciation of the domestic currency, making exports less competitive and imports
cheaper.
• Sudden capital outflows: If investors lose confidence in a country's economy, they
may withdraw their investments, leading to a sudden outflow of capital and a
depreciation of the domestic currency.
• Currency speculation: Speculators may bet on the depreciation of a currency,
leading to a self-fulfilling prophecy and a decline in the currency's value.

Evolution of the International Monetary System

The international monetary system has evolved significantly over time, with different systems
and arrangements being adopted at various points.

The Gold Standard (1870-1914)

Under the gold standard, currencies were convertible into gold at a fixed rate. This system
provided stability and predictability, but it was vulnerable to shocks, such as wars and
economic crises.

The Bretton Woods System (1944-1971)

The Bretton Woods system established the International Monetary Fund (IMF) and the World
Bank. The U.S. dollar served as the key currency, convertible into gold at a fixed rate. Other
currencies were pegged to the dollar. This system provided stability but was eventually
undermined by U.S. balance of payments deficits and growing inflation.

The Flexible Exchange Rate Regime (1971-Present)

After the collapse of the Bretton Woods system, most major currencies adopted a flexible
exchange rate regime, where their values are determined by market forces. This system
provides greater flexibility but can also lead to increased volatility.

Current Exchange Rate Arrangements

• Floating Exchange Rates: Most major currencies, such as the U.S. dollar, euro, and
yen, float freely against each other.
• Pegged Exchange Rates: Some countries peg their currencies to a major currency,
such as the U.S. dollar or the euro.
• Managed Float: Some countries manage their exchange rates through intervention in
the foreign exchange market.

The Economic and Monetary Union (EMU)

The EMU is a monetary union among 19 member states of the European Union (EU). These
countries have adopted a common currency, the euro, and a common central bank, the
European Central Bank (ECB). The EMU aims to promote economic integration and stability
within Europe.
UNIT 3
Foreign Exchange Market: A Comprehensive Overview

The Foreign Exchange Market (Forex or FX) is a global decentralized

market where currencies are traded. It's the largest and most liquid
financial market in the world, facilitating the exchange of one
currency for another.

Functions of the Forex Market

1. Currency Conversion: The primary function is to convert one

currency into another to facilitate international trade and
investment.
2. Hedging: Businesses and individuals use the Forex market to
hedge against currency risk, protecting themselves from
potential losses due to unfavorable exchange rate fluctuations.
3. Speculation: Some market participants engage in speculation,
buying and selling currencies to profit from short-term price
movements.
4. Arbitrage: Traders seek to profit from price differences in
different markets by buying a currency in one market and selling
it in another at a higher price.

Structure of the Forex Market

The Forex market is an over-the-counter (OTC) market, meaning

there's no physical exchange. Transactions occur directly between two
parties, typically through financial institutions.

Key Participants in the Forex Market

 1. Commercial Banks: They act as intermediaries, facilitating
currency exchange for their clients, including businesses and
individuals.
2. Central Banks: They intervene in the market to influence
exchange rates and maintain monetary stability.
3. Investment Banks: They engage in currency trading on their
own account and for their clients.
4. Hedge Funds: These funds actively trade currencies to generate
profits.
5. Retail Forex Traders: Individual investors who trade
currencies through online brokers.
6. Corporations: Businesses involved in international trade use
the Forex market to manage currency risk.

Types of Transactions and Settlement Dates

1. Spot Transactions: The simplest type, involving the immediate

exchange of currencies at the prevailing spot rate. Settlement
typically occurs within two business days.
2. Forward Transactions: Contracts to buy or sell a specific
amount of currency at a future date at a predetermined exchange
rate.
3. Futures Contracts: Standardized contracts traded on
exchanges, allowing participants to speculate on future currency
price movements.
4. Options Contracts: Give the buyer the right, but not the
obligation, to buy or sell a currency at a specific price on or
before a certain date.

Exchange Rate Quotations

Exchange rates are typically quoted in pairs. For example, EUR/USD

represents the exchange rate between the Euro and the US Dollar.
There are two main ways to quote exchange rates:

1. Direct Quotation: The domestic currency price of one unit of

foreign currency. For example, USD/JPY 100 means 1 US
Dollar equals 100 Japanese Yen.
 2. Indirect Quotation: The foreign currency price of one unit of
domestic currency.

For example, EUR/USD 1.10 means 1 Euro equals 1.10 US Dollars.

Nominal Exchange Rate

• The nominal exchange rate is the rate at which one currency can
be exchanged for another. It's the simple price of one currency
in terms of another.
• For example, if the nominal exchange rate between the US
dollar and the Euro is 1.10, it means that 1 US dollar can be
exchanged for 1.10 Euros.

Real Exchange Rate

• The real exchange rate adjusts the nominal exchange rate for
differences in price levels between countries. It measures the
relative purchasing power of two currencies.
• Real Exchange Rate = Nominal Exchange Rate * (Domestic
Price Level / Foreign Price Level)
• A higher real exchange rate means that domestic goods and
services are more expensive relative to foreign goods and
services.

Effective Exchange Rate

• The effective exchange rate measures the overall value of a

currency relative to a basket of other currencies. It's a weighted
average of bilateral exchange rates.
• Nominal Effective Exchange Rate (NEER): A weighted average
of a currency's value against a basket of other currencies.
• Real Effective Exchange Rate (REER): The NEER adjusted for
relative price levels.
Determination of Exchange Rates in Spot Markets

Exchange rates in spot markets are primarily determined by supply

and demand forces. Several factors influence these forces:

1. Economic Fundamentals:
o Interest Rate Differentials: Higher interest rates in a
country tend to attract foreign investment, increasing
demand for its currency.
o Inflation Rates: A country with higher inflation tends to
see its currency depreciate relative to countries with lower
inflation.
o Economic Growth: Strong economic growth can lead to
increased demand for a country's currency.
o Current Account Balance: A current account surplus
indicates a strong economy and can strengthen a
currency.
2. Market Sentiment and Speculation:
o Investor and trader sentiment can significantly impact
exchange rates.
o Speculation can lead to short-term fluctuations in
exchange rates.
3. Government Intervention:
o Central banks may intervene in the foreign exchange
market to influence exchange rates, often to stabilize their
currencies or to support economic growth.
4. Political and Geopolitical Factors:
o Political instability, geopolitical tensions, and natural
disasters can affect a country's currency.

Determination of Exchange Rates in Forward Markets

In forward markets, exchange rates are primarily determined by

the interest rate differential between two currencies and the
spot exchange rate. This relationship is often referred to as
Interest Rate Parity (IRP).

Interest Rate Parity (IRP)

 IRP states that the difference between the interest rates of two
countries should be equal to the difference between the forward
exchange rate and the spot exchange rate.

Key Factors Influencing Forward Rates:

1. Interest Rate Differentials:

o Higher Domestic Interest Rate: If a country's domestic
interest rate is higher than the foreign interest rate, the
forward rate will be at a premium to the spot rate. This is
because investors would be willing to pay more in the
future to lock in the higher domestic interest rate.
o Lower Domestic Interest Rate: Conversely, if the
domestic interest rate is lower than the foreign interest
rate, the forward rate will be at a discount to the spot rate.
2. Market Expectations:
o Expected Future Spot Rate: Market expectations about
future exchange rate movements can influence the forward
rate. If the market expects the domestic currency to
appreciate, the forward rate will be at a premium.
o Risk Premium: The forward rate may also incorporate a
risk premium to account for uncertainties and potential
risks associated with the foreign currency.
3. Market Arbitrage:
o Arbitrageurs take advantage of pricing discrepancies to
profit. They will buy and sell currencies in different
markets to exploit any deviations from IRP. This arbitrage
activity helps to keep the forward rate in line with the
interest rate differential.

Exchange Rate Behavior

Exchange rates are influenced by a variety of economic, political, and

psychological factors. These factors include:

• Economic Factors: Interest rates, inflation rates, economic

growth, current account balances, and fiscal policies.
 • Political Factors: Government stability, political risk, and
geopolitical events.
• Psychological Factors: Market sentiment, speculation, and herd
behavior.

Cross Rates

Cross rates are exchange rates between two currencies that are not
directly quoted. They are derived from the exchange rates of each
currency against a third currency, usually the US dollar. For example,
if you know the exchange rates of EUR/USD and USD/JPY, you can
calculate the EUR/JPY cross rate.

Arbitrage Profit in Foreign Exchange Markets

Arbitrage is the practice of taking advantage of price differences in

different markets to make a risk-free profit. In the foreign exchange
market, arbitrage opportunities arise when the exchange rates between
three or more currencies are inconsistent.

Types of Arbitrage

• Triangular Arbitrage: This involves buying and selling three

currencies to profit from discrepancies in exchange rates.
• Two-Point Arbitrage: This involves buying a currency in one
market and selling it in another to profit from price differences.

SWIFT (Society for Worldwide Interbank Financial

Telecommunication)

SWIFT is a cooperative society that provides a secure network that

enables financial institutions worldwide to send and receive
information about financial transactions. It plays a crucial role in the
global financial system by facilitating the exchange of messages and
funds between banks.

Key Points about SWIFT:

• It's a messaging network, not a payment system.

 • It's used to send instructions for payments, rather than the actual
funds.
• It ensures secure and efficient communication between banks.

Triangular and Locational Arbitrage

Triangular Arbitrage Triangular arbitrage is a strategy that exploits

pricing discrepancies among three different currencies. It involves
three trades:

1. Currency Exchange 1: Convert the initial currency into a

second currency.
2. Currency Exchange 2: Convert the second currency into a
third currency.
3. Currency Exchange 3: Convert the third currency back into the
initial currency.

If the exchange rates are not aligned, an arbitrage opportunity arises.

For instance, consider the following exchange rates:

• USD/EUR = 1.10
• EUR/GBP = 0.89
• GBP/USD = 1.23

To exploit this opportunity, you could:

1. Start with 100 USD.

2. Convert it to EUR: 100 USD * 1.10 EUR/USD = 110 EUR.
3. Convert EUR to GBP: 110 EUR * 0.89 GBP/EUR = 97.9 GBP.
4. Convert GBP back to USD: 97.9 GBP * 1.23 USD/GBP =
120.27 USD.

You would end up with more USD than you started with, realizing a
risk-free profit.

Locational Arbitrage Locational arbitrage involves exploiting price

differences for the same asset in different markets. This can occur in
various markets, including:
 • Foreign Exchange Markets: Buying a currency in one market
and selling it in another at a higher price.
• Stock Markets: Buying a stock on one exchange and selling it
on another at a higher price.
• Commodity Markets: Buying a commodity in one market and
selling it in another at a higher price.

For example, if a stock is trading at $100 on the New York Stock

Exchange (NYSE) and $102 on the London Stock Exchange (LSE),
an arbitrageur could buy the stock on the NYSE and sell it on the LSE
to profit from the price difference.
UNIT 4
International Financial Markets and Instruments: Foreign
Portfolio Investment, International Bond and Equity Markets

Foreign Portfolio Investment (FPI)

Foreign Portfolio Investment (FPI) involves investing in foreign

securities like stocks and bonds without taking control of the
underlying assets. It's a passive investment strategy, primarily focused
on financial returns.

Key Characteristics of FPI:

• Short-term Nature: Often considered a short-term investment

strategy.
• Portfolio Diversification: Spreads risk across different
geographies and asset classes.
• High Liquidity: Investments can be easily bought and sold.
• Lower Risk: Generally considered less risky than Foreign
Direct Investment (FDI).

Benefits of FPI:

• Diversification: Reduces portfolio risk by investing in different

markets.
• Higher Returns: Potential for higher returns than domestic
investments.
• Access to Global Markets: Invests in companies operating in
global markets.
• Currency Appreciation: Benefits from currency appreciation.

International Bond Market

The international bond market is a global marketplace where

governments and corporations issue debt securities denominated in
foreign currencies. These bonds are traded across borders, offering
investors a diverse range of investment opportunities.
Types of International Bonds:

• Eurobonds: Bonds issued outside the country of the currency in

which they are denominated. For example, a Eurodollar bond is
a dollar-denominated bond issued outside the US.
• Foreign Bonds: Bonds issued by a foreign entity in a domestic
market and denominated in the domestic currency. For example,
a Yankee bond is a dollar-denominated bond issued in the US
by a foreign entity.
• Global Bonds: Bonds issued simultaneously in multiple
markets, often denominated in multiple currencies.

Factors Affecting International Bond Markets:

• Interest Rates: Interest rate fluctuations impact bond prices.

• Exchange Rates: Changes in exchange rates can affect the
value of foreign bond investments.
• Economic Conditions: Economic growth, inflation, and
political stability influence bond markets.
• Credit Ratings: Credit ratings assigned to bond issuers impact
their perceived risk and, consequently, bond prices.

International Equity Market

The international equity market allows investors to buy and sell

shares of foreign companies. This provides access to a wider range of
investment opportunities and potential for higher returns.

Key Considerations for International Equity Investment:

• Currency Risk: Fluctuations in exchange rates can impact

returns.
• Political Risk: Political instability can affect the performance of
foreign stocks.
• Economic Risk: Economic downturns in foreign countries can
negatively impact stock prices.
• Market Risk: Global market volatility can affect the overall
performance of international equity investments.
Strategies for International Equity Investment:

• Direct Investment: Buying shares of individual foreign

companies.
• Mutual Funds: Investing in funds that pool money from
various investors to invest in foreign stocks.
• Exchange-Traded Funds (ETFs): Investing in ETFs that track
specific foreign stock indices.

Global Depositary Receipts (GDRs)

• Definition: A financial instrument issued by a depository bank

representing a specific number of shares of a foreign company.
• Purpose: To facilitate the trading of foreign shares in
international markets, particularly in Europe.
• Advantages:
o Increased Liquidity: GDRs can enhance liquidity for a
company's shares, especially in markets where trading
volumes may be low.
o Access to International Capital: Companies can raise
capital from a wider pool of international investors.
o Enhanced Corporate Image: GDRs can improve a
company's international profile and brand recognition.
• Disadvantages:
o Complex Regulatory Environment: Issuing and listing
GDRs can involve complex regulatory hurdles.
o Currency Risk: Investors are exposed to currency
exchange rate fluctuations.
o Potential for Lower Liquidity: GDRs may have lower
liquidity compared to domestic shares.

American Depositary Receipts (ADRs)

• Definition: A financial instrument issued by a U.S. depository

bank representing a specific number of shares of a foreign
company.
 • Purpose: To facilitate the trading of foreign shares in the U.S.
stock market.
• Advantages:
o Increased Liquidity: ADRs can enhance liquidity for a
company's shares in the U.S. market.
o Access to U.S. Capital: Companies can raise capital from
U.S. investors.
o Enhanced Corporate Image: ADRs can improve a
company's international profile and brand recognition.
• Disadvantages:
o Regulatory Compliance: ADRs are subject to U.S.
securities regulations.
o Currency Risk: Investors are exposed to currency
exchange rate fluctuations.

Cross-Listing of Shares

• Definition: The listing of a company's shares on multiple stock

exchanges around the world.
• Purpose: To increase a company's visibility, liquidity, and
access to capital.
• Advantages:
o Enhanced Liquidity: Increased trading volume and price
discovery.
o Improved Corporate Governance: Adherence to stricter
regulatory standards.
o Enhanced Investor Relations: Improved communication
with a diverse investor base.
• Disadvantages:
o Increased Costs: Higher regulatory and compliance costs.
o Currency Risk: Exposure to currency exchange rate
fluctuations.
o Complex Regulatory Environment: Dealing with
multiple regulatory jurisdictions.

Global Registered Shares (GRS)

 • Definition: A type of share that can be traded on multiple stock
exchanges around the world.
• Purpose: To streamline the process of issuing and trading
shares internationally.
• Advantages:
o Simplified Issuance and Trading: A single class of
shares can be traded on multiple exchanges.
o Reduced Costs: Lower administrative and legal costs.
o Enhanced Investor Base: Access to a wider range of
investors.

International Financial Instruments: A Deeper Dive

Foreign Bonds and Eurobonds

Foreign Bonds

• Issued by a foreign entity in a domestic market and denominated

in the domestic currency.
• For example, a Yankee bond is a dollar-denominated bond
issued in the US by a foreign entity.
• Key Features:
o Subject to domestic regulations.
o Often targeted at domestic investors.
o Can offer tax advantages to domestic investors.

Eurobonds

• Issued outside the country of the currency in which they are

denominated.
• For example, a Eurodollar bond is a dollar-denominated bond
issued outside the US.
• Key Features:
o Less regulatory oversight than domestic bonds.
o Often issued in bearer form, making them more
anonymous.
o Can be issued in a variety of currencies.
Global Bonds

• Issued simultaneously in multiple markets and denominated in

multiple currencies.
• Combine the features of foreign and Eurobonds.
• Key Features:
o Larger investor base.
o Greater liquidity.
o Lower borrowing costs.

Floating Rate Notes (FRNs)

• Bonds whose coupon rate adjusts periodically based on a

benchmark interest rate.
• Key Features:
o Interest rate risk is reduced.
o Suitable for investors seeking income and protection
against rising interest rates.
o Often issued by banks and financial institutions.

Zero-Coupon Bonds

• Bonds that do not pay periodic interest payments.

• Instead, they are sold at a discount to their face value and
redeemed at par at maturity.
• Key Features:
o No reinvestment risk.
o Suitable for long-term investors.
o Often used for tax-deferred savings plans.

Other Notable International Financial Instruments:

• Convertible Bonds: Bonds that can be converted into a specific

number of shares of the issuing company's common stock.
• Asset-Backed Securities (ABS): Bonds backed by a pool of
assets, such as mortgages, car loans, or credit card receivables.
• Collateralized Debt Obligations (CDOs): Complex financial
instruments backed by a pool of assets, often structured into
tranches with varying levels of risk and return.
Factors Affecting International Financial Instruments:

• Interest Rates: Interest rate fluctuations impact the value of

fixed-income securities.
• Exchange Rates: Changes in exchange rates can affect the
value of foreign currency-denominated securities.
• Economic Conditions: Economic growth, inflation, and
political stability influence the performance of international
financial instruments.
• Credit Ratings: Credit ratings assigned to issuers impact the
perceived risk of their securities.
• Market Sentiment: Investor sentiment and market volatility
can affect the prices of international financial instruments.

International Money Markets and International Banking Services

International Money Markets

International money markets are global financial markets that deal

with short-term debt instruments, typically with maturities of less than
one year. These markets facilitate the flow of short-term funds
between countries.

Key Instruments in International Money Markets:

• Eurocurrency Deposits: Deposits denominated in a currency

different from the currency of the country where the bank is
located. For example, Eurodollars are US dollar-denominated
deposits held in banks outside the US.
• Certificates of Deposit (CDs): Short-term debt instruments
issued by banks.
• Commercial Paper: Short-term unsecured promissory notes
issued by corporations.
• Bankers' Acceptances: Time drafts drawn on and accepted by
a bank.
International Banking Services

International banking services allow banks to conduct business across

borders. Key services include:

1. Correspondent Banking

• Definition: A banking relationship between two banks in

different countries.
• Purpose: To facilitate international transactions, such as
remittances, trade finance, and foreign exchange.
• Benefits:
o Expanded global reach
o Reduced operational costs
o Enhanced risk management

2. Representative Offices

• Definition: A non-banking office established by a foreign bank

to promote its services and build relationships.
• Purpose: Market research, business development, and liaison
with local authorities.
• Limitations: Cannot undertake full-fledged banking activities
like accepting deposits or lending money.

3. Foreign Branches

• Definition: A branch of a foreign bank established in a host

country.
• Purpose: To conduct a full range of banking activities,
including accepting deposits, making loans, and foreign
exchange transactions.
• Benefits:
o Direct customer relationships
o Greater control over operations
o Enhanced brand recognition

Forward Rate Agreements (FRAs)

 • Definition: A contract between two parties to exchange interest
rate payments on a notional principal amount.
• Purpose: To hedge against interest rate risk.
• How it Works:
o Parties agree on a fixed interest rate for a specified period.
o At the end of the period, the difference between the fixed
rate and the actual market interest rate is settled.

Key Benefits of FRAs:

• Risk Management: Hedging against interest rate fluctuations.

• Speculation: Profiting from anticipated interest rate
movements.
• Flexibility: Customizable terms and maturities.
UNIT 5
International Parity Relationships and Forecasting Foreign
Exchange Rates

Measuring Exchange Rate Movements

Exchange rates can be measured in various ways:

• Nominal Exchange Rate: The rate at which one currency can

be exchanged for another.
• Real Exchange Rate: The nominal exchange rate adjusted for
price level differences between countries.
• Effective Exchange Rate: A weighted average of a currency's
value relative to a basket of other currencies.

Exchange Rate Equilibrium

Exchange rate equilibrium occurs when the demand for a currency

equals its supply. Factors affecting exchange rate equilibrium include:

• Economic Fundamentals:
o Interest Rate Differentials: Higher interest rates attract
foreign capital, increasing demand for the currency.
o Inflation Rates: Higher inflation erodes purchasing power,
leading to currency depreciation.
o Economic Growth: Strong economic growth boosts
demand for a country's currency.
o Current Account Balance: A current account surplus
strengthens a currency.
• Market Sentiment and Speculation:
o Investor and trader sentiment can significantly impact
exchange rates.
o Speculative activity can lead to short-term volatility.
• Government Intervention:
o Central banks may intervene to influence exchange rates
through foreign exchange market operations or monetary
policy.
 • Political and Geopolitical Factors:
o Political instability, geopolitical tensions, and natural
disasters can affect a country's currency.

Forecasting Foreign Exchange Rates

Several methods are used to forecast exchange rates:

1. Fundamental Analysis:

• Analyzing economic indicators like GDP growth, inflation,

interest rates, and current account balances.
• Using econometric models to forecast future exchange rates
based on historical data and economic relationships.

2. Technical Analysis:

• Studying historical price charts and patterns to identify trends

and potential future movements.
• Using technical indicators like moving averages, relative
strength index (RSI), and Bollinger Bands to generate trading
signals.

3. Market Sentiment Analysis:

• Analyzing news, social media, and investor sentiment to gauge

market expectations.
• Using sentiment analysis tools to quantify market sentiment.

4. International Parity Conditions:

• Purchasing Power Parity (PPP): States that the exchange rate

between two currencies should equal the ratio of the price levels
of a basket of goods in the two countries.

• Interest Rate Parity (IRP): States that the interest rate

differential between two countries should equal the forward
exchange rate premium or discount.

Key Challenges in Forecasting Exchange Rates:

 • Market Volatility: Exchange rates can be highly volatile,
making accurate forecasts difficult.
• Unpredictable Events: Political events, natural disasters, and
economic shocks can significantly impact exchange rates.
• Market Sentiment: Investor sentiment and speculative activity
can drive short-term exchange rate movements.

Interest Rate Parity (IRP)

IRP states that the interest rate differential between two countries
should equal the forward exchange rate premium or discount. In
simpler terms, it suggests that investors should expect to earn the
same return on investments in different countries, after adjusting for
exchange rate movements.

Implications of IRP:

• Hedging: Investors can use forward contracts to lock in

exchange rates and protect against currency risk.
• Arbitrage Opportunities: Deviations from IRP can create
arbitrage opportunities for traders to profit.
• Central Bank Policy: Central banks can influence exchange
rates by adjusting interest rates.

Purchasing Power Parity (PPP)

PPP states that the exchange rate between two currencies should equal
the ratio of the price levels of a basket of goods in the two countries. 1
In other words, a unit of currency should be able to purchase the same
quantity of goods in different countries.

Types of PPP:

• Absolute PPP: This suggests that the price of a specific basket

of goods should be the same in all countries when expressed in a
common currency.
 • Relative PPP: This suggests that the rate of change in the
exchange rate between two currencies should equal the
difference in inflation rates between the two countries.

Implications of PPP:

• Long-Term Exchange Rate Movements: PPP can help explain

long-term trends in exchange rates.
• Inflation and Exchange Rates: Countries with higher inflation
rates tend to experience currency depreciation.
• Investment Decisions: PPP can be used to assess the relative
attractiveness of different investment markets.

Limitations of IRP and PPP:

• Transaction Costs: Transaction costs can limit the

effectiveness of arbitrage opportunities and the accuracy of PPP.
• Market Imperfections: Government regulations, trade barriers,
and market frictions can hinder the adjustment of exchange rates
to parity levels.
• Non-Traded Goods and Services: PPP may not hold for non-
traded goods and services, such as haircuts and housing.
• Short-Term Deviations: Exchange rates can deviate from
parity levels in the short term due to market sentiment,
speculative activity, and other factors.

Foreign Exchange Risk Management

Foreign exchange risk, also known as currency risk, arises from the
potential for losses due to unfavorable fluctuations in exchange rates.
To mitigate this risk, businesses often employ various hedging
techniques.

Hedging Techniques

1. Forward Market:
 • Definition: A market where participants agree to exchange
currencies at a future date at a predetermined exchange rate.
• How it Works: A company can enter into a forward contract to
buy or sell a specific amount of foreign currency at a fixed rate,
thereby locking in the exchange rate.
• Advantages:
o Certainty of exchange rate.
o Simple to understand and execute.
• Disadvantages:
o Less flexibility compared to options.
o Potential for missed opportunities if exchange rates move
favorably.

2. Futures Market:

• Definition: A standardized exchange-traded contract to buy or

sell a specific quantity of a currency at a future date at a
predetermined price.
• How it Works: Similar to forward contracts, but traded on
exchanges.
• Advantages:
o Liquidity and standardized contracts.
o Lower transaction costs.
• Disadvantages:
o Less flexibility in terms of contract specifications.
o Potential for margin calls if the market moves against the
position.

3. Options Market:

• Definition: A contract that gives the buyer the right, but not the
obligation, to buy or sell a specific currency at a predetermined
price (strike price) on or before a specific date (expiration date).
• Types of Options:
o Call Option: Gives the buyer the right to buy a currency.
o Put Option: Gives the buyer the right to sell a currency.
• Advantages:
o Flexibility to hedge or speculate.
 o Limited downside risk.
• Disadvantages:
o Option premiums can be costly.

4. Currency Swaps:

• Definition: An exchange of principal amounts and interest

payments in different currencies.
• How it Works: Two parties agree to exchange principal
amounts and interest payments on a specified notional amount
of debt.
• Advantages:
o Hedging interest rate and currency risk.
o Access to foreign currency funding.
• Disadvantages:
o Complex contracts and counterparty risk.

5. Interest Rate Swaps:

• Definition: An exchange of interest rate payments on a notional

principal amount.
• How it Works: Two parties agree to exchange fixed-rate and
floating-rate interest payments.
• Advantages:
o Hedging interest rate risk.
o Access to different types of interest rate markets.
• Disadvantages:
o Counterparty risk.

6. Hedging Through Currency of Invoicing:

• Definition: Invoicing transactions in a currency that is stable or

expected to appreciate.
• Advantages:
o Reduced exposure to currency fluctuations.
o Simplified financial management.
• Disadvantages:
o May not always be feasible, especially for smaller
businesses.
7. Hedging Through Mixed Currency Invoicing:

• Definition: Invoicing a portion of the transaction in a stable

currency and the remainder in the local currency.
• Advantages:
o Balanced approach to currency risk management.
o Increased flexibility.
• Disadvantages:
o More complex invoicing process.

Country Risk Analysis: Country risk analysis involves assessing the

political, economic, and social factors that could impact a company's
operations in a foreign country. This helps identify potential risks and
develop appropriate hedging strategies.